Financing and Ownership Structures in International Project Finance
by
David BENOUAICH
Ingenieur Civil
Ecole Polytechnique F6derale de Lausanne, 1997
Submitted to the Department of Civil and Environmental Engineering in partial
fulfillment of the requirement for the Degree of
Master of Science in
Civil and Environmental Engineering
at the
MASSACHUSETTS INSTITUTE OF TECHNOLOGY
May 2000
©2000 David Benouaich
All rights reserved
The author hereby gra nts to MIT permission to reproduce and distribute publicly
paper and electronic copies of this thesis document in whole or in nart.
Signature of Author
................
..
Depprmdit of Civil and Environmental Engineering
May 5, 2000
Certified by
.....................
Massood V. Samii
Thesis Supervisor
Lecturer, Center forConstruction Respprch and Education
Accepted by
.............
Professor Daniele Veneziano
Chairman, Departmental Committee on Graduate Studies
MASSACHUSETTS INSTITUTE
OF TECHNOLOGY
MAY
7 F
2oo
LIBRARIES
ENG
Financing and Ownership Structures in
International Project Finance
by
David BENOUAICH
Submitted to the Department of Civil and Environmental Engineering on May 5,
2000 in partial fulfillment of the requirements for the Degree of Master of Science
in Civil and Environmental Engineering
Abstract
In the past twenty years there has been a new wave of global interest in
project finance as a tool for financing capital-intensive projects all around the
world. The crucial elements in structuring a project finance transaction are: the
risk allocation process, the determination of the best type of ownership structure,
and the development of a complete and integrated set of financial and
contractual arrangements.
This thesis examines the ownership and financing structures in
International Project Finance. Selection of the form of business organization for
a project is an important step in project development and depends on a variety of
business, legal, accounting, tax and regulatory factors. This thesis presents four
forms of ownership structure most frequently used for developing a project and
highlights the reasons of selecting one of them.
The variety of sources of funds, with a trend towards the increasing
development of sophisticated capital market instruments, provides project
sponsors with flexibility to select the appropriate structure to finance a project.
This thesis presents the three types of capital used in project financing and
details the alternatives for financing a project from its development phase to its
operating phase showing that the project financing is a dynamic process.
After having developed a basic framework for structuring an international
project finance transaction, this thesis ends by exposing projects financed on a
project-financing basis. These projects are characterized by some specific
features, such as refinancing prior to project completion or use of capital market
financing.
Thesis Supervisor: Professor Massood V. Samii
Title: Lecturer, Center for Construction Research and Education
Acknowledgments
I would like to thank Professor Massood V. Samii for his supervision and
guidance.
I express my deepest gratitude to Professor Klaus Schwab for supporting
my ambition to study at MIT.
I am also particularly grateful to Professor Marc Badoux for his guidance
and assistance that have enabled me to develop and broaden my horizons.
I would also like to thank Professor Ian Smith for his strong commitment,
which has contributed to my admission to the Construction Engineering and
Management Program at MIT.
My dearest regards go to Frangoise Binelli for her permanent support and
encouragement since our first meeting on September 1981, who has finally made
all this possible.
Finally, I would like to dedicate this thesis to my parents and my brother
Micha6l who have continuously encouraged and supported me in making my
dreams come true.
David Benouaich
Cambridge, MA
May 5, 2000
3
Table of Contents
Title page
Abstract
Acknowledgements
Table of contents
Table of figures and tables
Introduction
9
1.1
Objectives
9
1.2
The Global Project Finance Market
10
An Introduction to Project Finance
19
1
2
2.1
A Historical Perspective
19
2.2
Definition of Project Finance
21
2.3
Reasons for Private-sector Participation
24
2.4
Uses of Project Finance
25
2.5
Limited-recourse Project Finance Structures
28
2.6
Advantages and Disadvantages of Project Financing
29
4
3
3.1
Project Finance Ownership Structures
Project Finance Participants, Their Roles and Objectives
36
36
3.1.1
Project Company
36
3.1.2
Project Sponsors
37
3.1.3
Commercial Lenders
39
3.1.4
Multilateral Agencies
40
3.1.5
Suppliers
41
3.1.6
Output Purchasers
42
3.1.7
Contractor
42
3.1.8
Operator
43
3.1.9
Host Government
44
3.2
Project Finance Participants Structure
45
3.3
Selection of the Project Finance Ownership Structure
46
3.3.1
Basic Forms of Project Finance Ownership Structures
47
3.3.2
Corporation
48
3.3.3
General Partnership
53
3.3.4
Limited Partnership
59
3.3.5
Joint Venture
62
3.4
Comparison of Alternative Forms of Organization for a Project
68
3.5
Public-Private Partnerships
71
4
Project Finance Security Arrangements
5
74
4.1
Role of Security Arrangements in Project Finance
74
4.2
Project Agreements and Contracts
75
4.2.1
Concession Agreement
75
4.2.2
Construction Contracts
77
4.2.3
Supply Agreements
78
4.2.4
Off-take Agreement
80
4.2.5
Operating and Maintenance Agreement
81
4.2.6
Cash Contribution Agreement
83
4.3
5
5.1
Project Finance Contractual Arrangements Structure
84
Project Financing Structures
85
Types of Capital and Debt
85
5.1.1
Equity
86
5.1.2
Quasi-equity
87
5.1.3
Senior Debt
88
5.2
89
Project Capital Structure
5.2.1
Project Financial Leverage
89
5.2.2
Reasons of High Project Financial Leverage
90
Construction Financing
95
5.3.1
Bank Loan Facility
95
5.3.2
Direct Loan by the Sponsors to the Project Company
96
5.3
6
5.4
5.4.1
Mezzanine Financing
5.4.2
Capital Market Financing
5.5
98
Long-term Financing
99
100
Project Financing Structures over Project Phases
102
5.5.1
Project Development Phase
103
5.5.2
Project Construction and Start-up Phase
104
5.5.3
Project Operation Phase
106
6
Examples of International Project Finance Transactions
108
6.1
The Indiantown Cogeneration Project
108
6.2
The Melbourne City Link Project
112
6.3
The Tribasa Toll Road Project
115
6.4
The Sydney Harbour Tunnel Project
118
Conclusion
121
References
127
7
Table of figures and tables
Fig. 1.1: Long-term private sector and project finance flows to developing countries, 1994-98
13
(Billions of U.S. dollars). Source: Capital DATA Project Finance Ware.
Table 1.1: Project finance transactions by region, 1997-98. Source: Capital DATA Project
14
Finance Ware.
Fig. 1.2: Volume of project finance transactions, 1994-98 (Billions of U.S. dollars). Source:
15
Capital DATA Project Finance Ware.
dollars).
of
U.S.
(Billions
1994-98
markets,
in
developing
transactions
finance
Project
Fig. 1.3:
16
Source: Capital DATA Project Finance Ware.
Fig. 1.4: Project finance transactions in developing countries by sector, 1994-98. Source: Capital
17
DATA Project Finance Ware.
45
Fig. 3.1: Project Finance Participants.
Table 3.1: Accounting considerations relative to percentage ownership of project corporation. 50
Fig. 3.2: Ownership Structure when a project is organized as a Corporation jointly owned by
51
several project sponsors. Adapted from Nevitt, Peter K.
Fig. 3.3: Ownership Structure when a project is organized as a General Partnership. Adapted
57
from Nevitt.
Fig. 3.4: Ownership Structure when a project is organized as a General Partnership using
58
corporate subsidiaries and corporate financing vehicle. Adapted from Nevitt.
Adapted
Partnership.
a
Limited
Fig. 3.5: Ownership Structure when a project is organized as
61
from Nevitt.
Fig. 3.6: Ownership Structure when a Project is organized as a Joint Venture for the development
64
and operation of a mine. Adapted from Nevitt.
Table. 3.2: Comparison of alternative forms of business organization for a project. Directly
70
adapted from Finnerty.
72
Table 3.3: Private-sector participation in project development.
Park.84
and
Buljevich
from
Adapted
structure.
arrangements
contractual
finance
Fig. 4.1: Project
96
Fig. 5.1: Ways of financing the construction phase of a project.
Fig. 5.2: Way of financing the construction phase of a project in which the project sponsor is
97
involved.
104
Fig. 5.3: Financing Structure during the Development Phase.
105
Fig. 5.4: Financing Structure during the Construction Phase before project completion.
106
completion.
project
time
of
at
the
Fig. 5.5: Financing Structure
107
Fig. 5.6: Financing Structure during the Operation Phase.
109
Fig. 6.1: Simplified ownership structure for the Indiantown Cogeneration Project.
110
Fig. 6.2: The Indiantown Cogeneration Project schedule.
111
Fig. 6.3: Capital structure upon project refinancing (Dollar Amounts in Millions).
8
1 Introduction
1.1
Objectives
This thesis examines the ownership and financing structures that are
currently used to shape a project finance transaction. Throughout the description
of mechanisms used both to select the best form of business organization to
undertake a project and to structure the financial arrangements supporting the
financing of the project, the thesis proposes a basic framework for developing a
project finance transaction.
Chapter 2 provides an introduction to project financing by presenting a
brief historical perspective, by exploring possible uses of this financing technique,
and by reviewing the advantages and disadvantages of the project financing
technique.
Then, Chapter 3 presents the most frequently forms of business
organization used to undertake a project on a project-financing basis. For each
form of ownership, the reasons associated with the choice of a particular type of
business organization are described.
Chapter 4 highlights the utmost importance of project contracts in
developing a project finance transaction, and therefore ensuring its success. The
project company usually enters with project contractors into different project
9
contracts for the purposes of the development of the project. Chapter 4 provides
the description of some of the most relevant project contracts, such as the offtake agreement, the supply agreement, or the construction contract. These
project contracts are essentially designed to give some certainty to the project.
Chapter 5 examines the current possible ways of financing a project.
First, this chapter describes the three types of capital used in project financing,
and advances some of the more common reasons for the high concentration of
debt in the project company. Then, this chapter details both construction
financing and permanent financing, and presents the alternatives used by the
project sponsors to finance a project. This chapter ends by showing project
financing as a dynamic process through the life of the project from its
development phase to its operating phase.
Finally, Chapter 6 advances some completed projects that are
characterized by special features, such as refinancing prior to project completion
or reliance on the international capital market for financing an infrastructure
project.
1.2
The Global Project Finance Market
In the past twenty years there has been a new wave of global interest in
project financing as a tool for financing capital-intensive projects. Though project
financing has been in use for hundreds of years, primarily in mining and natural
resource projects, its application to new types of projects is recent. Developing
10
countries have particularly benefited from the broadening of project finance
applications, as illustrated by some of recent examples of IFC-supported
projects':
L In Argentina, in 1993, the project finance technique helped raise
$329 million to finance the rehabilitation and expansion of Buenos
Aires' water and sewerage services, based on a new 30-year
concession. This investment, financed with IFC support, has
helped improve water quality and service to a city of more than 6
million of people;
"
In Hungary, in 1994, the project finance technique helped finance a
15-year concession to develop, install, and operate a nationwide
digital cellular network. The $185 million joint venture project was
an important part of the government's privatization program.
Because of difficulty attracting commercial financing at that time,
the project relied heavily on $109 million in debt and equity
financing from IFC and the U.S. Overseas Private Investment
Corporation (OPIC);
"
In China, in 1997, the project finance technique was used to
finance a $57 million greenfield project to install modern fiberboard
plants in interior china to support China's fast-growing construction
industry. IFC helped arrange $26 million in syndicated loans at a
1
This section is based on Project Finance in Developing Countries, Washington DC: International
Finance Corporation (IFC), April 1999.
11
time when foreign commercial banks remained cautious about
project financing in China's interior provinces;
u
In Mozambique, in 1998, the project finance technique helped
establish a $1.3 billion greenfield aluminum smelter. MOZAL, the
largest private-sector project in the country to date, is expected to
generate significant benefits in employment, export earnings, and
infrastructure development. IFC fostered the project by serving as
legal coordinator and preparing an independent analysis of project
viability. IFC also supported the project with $120 million in senior
and subordinated loans.
Globalization has brought a rapid increase in international capital flows, a
wider range of financial instruments, and new investors. Between 1990 and
1997, long-term flows to private-sector borrowers in developing countries rose
from about $44 billion to $322 billion, as illustrated in Figure 1.1.
12
400-
......
........-...........
...........
--........................
..............-...............
- -....
-.....
- -.............
-. .- - - --.. - ----...............
300
200
100
0
1994
1995
1996
1997
1998
Year
0 Private Sector Capital Flows N Project Finance Flows
Fig. 1.1: Long-term private sector and project finance flows to developing countries, 1994-98
(Billions of U.S. dollars). Source: Capital DATA Project Finance Ware.
Globalization has also greatly benefited project finance. Project finance
flows to emerging markets have considerably increased from less than $20 billion
in 1994 to an estimated $123 billion in 1997. At the same time, project finance
has itself helped to strengthen the effects of globalization. The liberalization and
spread of financial markets have given rise to new financial instruments and a
wider range of risk management techniques. Project finance, which relies
heavily on the mitigation of project risks, has used these new financial products
to develop and finance numerous projects.
The surge of project finance was particularly strong in 1996 and 1997,
stimulated by large flows of international capital. In 1997, the number of project
finance transactions worldwide exceeded 600, many of them in developing
countries, and their value topped $236 billion, as illustrated in Table 1.1.
Although in 1998 this value dropped back to about $111 billion, such activity can
13
still be seen as very positive taking into account the impact of the Asian financial
crisis.
Region
Europe
Asia
Latin America
North America
Middle East and North Africa
Sub-Saharan Africa
Number of Project
1997
1998
207
104
191
63
49
105
33
75
14
35
8
11
Total
Share of developing countries
624
380
271
140
Amount
(billion of U.S. dollars)
1997
1998
26.2
81.7
27.5
58.4
41.6
33.6
28.4
15.0
22.9
7.2
2.1
3.4
236.4
123.2
111.6
60.1
Table 1.1: Project finance transactions by region, 1997-98. Source: Capital DATA Project
Finance Ware.
Project finance flows to emerging markets reached an estimated $123
billion in 1997 before the financial crisis. The growth in the number of
transactions was also consequent, rising from less than 50 in 1994 to more than
400 in 1996 and 380 in 1997, before declining significantly in 1998. Despite the
financial crisis that began in mid-1 997, the investment needs in many developing
countries remain enormous. Meeting these needs will require a continuous
reliance on and appeal of private-sector participation.
Most project finance transactions of the past two decades have been
concluded in industrial countries, but the project financing technique has also
played a significant role in some developing markets. In 1997 and 1998,
combined project finance flows to developing countries totaled about $183 billion,
representing more than half of the total project finance flows recorded worldwide,
as shown in Figure 1.2.
14
250 ,
200
un
150
C6
D100
50 -
0 -L
1994
1995
1996
1997
1998
Year
MAll countries U Developing countries
Fig. 1.2: Volume of project finance transactions, 1994-98 (Billions of U.S. dollars). Source:
Capital DATA Project Finance Ware.
The volume of project finance transactions to developing countries, in
terms of percentage of the volume of total project finance transactions, has
increased from about 43% in 1996 to 54% in 1998 despite the significant
reduction of the number of project finance transactions. As a result, it is now
standard practice for large and complex projects in the major developing
countries to use project finance as a technique to finance new economic
investments. The volume of project finance transactions concluded in 1996 and
1997 before the financial crisis would have been hard to imagine a decade ago.
Project financing has not flowed to all countries and all geographic
regions, just as all regions have not benefited equally from the dramatic increase
in private international capital flows. Through 1997 the lion's share of project
15
finance volumes went to Asia (with about 34% of flows), although its relative
share declined in 1997 and more significantly in 1998, as illustrated in Figure 1.3.
150
-
-
-
-
-
-
--
-
120
S90
0
'0
-
60
30
0 1994
NEWN
MEN,
1995
1996
1997
1998
Year
* Latin America and the Caribean
o Europe
* Central Asia, Middle East, and North Africa
U Asia
* Sub-Saharan Africa
Fig. 1.3: Project finance transactions in developing markets, 1994-98 (Billions of U.S. dollars).
Source: Capital DATA Project Finance Ware.
Between 1994 and 1998, Asia received 41 % of the estimated flows to
developing countries, followed by Latin America and the Caribbean with a share
of 31%. Asia' dominance until mid-1997, and Latin America's since then (with
about 56% of flows in 1998), was due to (1) high levels of domestic investment
and growth, (2) macroeconomic stability, which increased the ability to attract
long-term financing essential to project finance development, and (3) a regulatory
framework relatively supportive of contract-based finance.
The sectorial distribution of project finance transactions in developing
markets over the period 1994-98 is illustrated in Figure 1.4. The importance of
infrastructure is clear, with 51% of flows over this period.
16
3% 2%1%
MInfrastructure
* Manufacturing
0 Oil, gas, and mining
o Chemical
13%
51%
mOther
0 Hotels and tourism
N Timber, pulp, and paper
o Food and agrobusiness
20%
Fig. 1.4: Project finance transactions in developing countries by sector, 1994-98. Source: Capital
DATA Project Finance Ware.
The financial and economic crisis that began in mid-1 997 in East Asia and
spread to other countries since then has dramatically slowed market evolution.
The number of projects in developing markets fell in 1998 to 140 for an amount
of $60 billion. The financial capacity and willingness of many banks in these
countries and of other potential investors to support large projects have also
been eroded. As a result, sponsors in crisis countries, both private and public,
have canceled or deferred numerous major projects. Projects under
implementation, which have been financed during the past few years, have come
under increased stress in the face of reduced market demand for their output or
related sponsor problems. With the prospects for economic growth slowing
worldwide, sponsors in other countries are also structuring their projects more
17
conservatively. Yet, when the growth of new investments picks up again, project
financing is likely to increase.
18
2 An Introduction to Project Finance
Infrastructure, oil and gas, telecommunication, water and other types of
large projects are more and more being developed by private entities who rely on
project finance as the most important financing technique available 2 . Indeed,
project sponsors and host country governments do not necessarily have the
creditworthiness to support new capital-intensive projects. Moreover, most of
these governments are not prepared to devote the necessary financial resources
for such projects. Additionally, project developers using the project finance
technique are able to exclude debt financing of the project company from their
own financial statements and avoid a downgrade of their credit rating.
Consequently, project financing is increasingly used to finance the still growing
need for infrastructure and other types of projects of both the developed and
developing world.
2.1
A Historical Perspective
Project financing is a well-established financing technique and has a long
history. Project financing can be traced back to the medieval times when in the
2 Buljevich,
Esteban C. and Park, Yoon S., Project Financing and the International Financial
Markets, Boston: Kluwer Academics Publishers, 1999.
19
12th century the British Crown negotiated with Frescobaldi, an Italian merchant
bank, a loan for the development of the Devon silver mines on the basis of a
production loan arrangement3 . The loan contract provided the lender with the
right to operate the mines for one year. During this year, the lender benefited
from the cash flow generated by the project but had to cover all the operating
expenses associated with the operation of the mines. On the other hand, the
British Crown guaranteed neither the quantity nor the quality of silver that could
be extracted from the mines during that period.
In the 19th century many infrastructure projects were financed using the
project financing technique. In Argentina (1860) and in India (1880) the
development of railways was principally financed by private entities whose
investments took the form of project finance. In 1850 the project financing
technique allowed the construction and the development of the Suez Canal. So,
the funding for large-scale public works such as the building of roads, railways,
and canals has come from private sources of capital throughout the
1 9 th
century.
The ownership and the management of infrastructures have gone through
cycles in the last century. Railroads, irrigation, and supply of power, water, and
gas were promoted, financed, and managed primarily by private-sector
enterprises. With time, infrastructure companies were regulated and
nationalized. Although the timing of public-sector involvement in infrastructure
3 Kensinger
and Martin (1988) discuss this example and provide an interesting summary of the
history of project financing.
20
development was not the same in the different countries, periods of war and
economic recession triggered waves of nationalization in most countries. In the
late 1950s, infrastructure services were largely provided by the public sector.
The drop in the quality of these services, which was associated with the
participation of the public sector, generated a wave of deregulation and
privatization during the 1970s. The private-sector participation in the
development of the infrastructures seems to be at the crest of this wave now.
2.2
Definition of Project Finance
Project financing 4 is a financing technique by which lenders agree to look
initially to the projected revenues of a project and the assets given in collateral as
the basis of their credit analysis and as the main source of repayment of their
loans, independently of the credit standing of the project developers. In general,
the term of "project finance" is used to refer to different kinds of financial
structures, in which the debt financing is based primarily on the projected
revenues from the operation of the project facility, and hence on the success of
the project itself. In other words, project financing can be arranged when the
project is capable of standing alone as an independent economic unit5.
4
Nevitt, Peter K., Project Financing: Fourth Edition, London: Euromoney Publications, 1983.
s Finnerty, John D., Project Financing: Asset-Based Financial Engineering, New York: John Wiley
& Sons, Inc., 1996.
21
Contrary to traditional corporate lending, project financing implies lending
on the assumption that the project cash flow and the project's assets provide
enough resources to repay debt financing. As a result, lenders, at least initially,
do not expect the project sponsors to contribute to debt service payments with
their own financial resources: "in true project financing, the project, its assets, its
cash flow and the project contracts are segregated from the developers in such a
way to permit the lenders to make their credit analysis of such project on an
isolated basis6 ." Such credit analysis aims to determine the economic viability of
the project. In other words, the lenders analyze the project to determine if it can
be considered economically, technically, financially, and legally sound enough to
generate adequate cash flows to meet the debt financing requirements.
According to Finnerty (1996), project financing typically includes the
following basic features:
u
An agreement by which financially responsible parties agree to
complete the project and to make available to the project all funds
required to achieve completion;
Li
An agreement by which financially responsible parties agree that,
when project completion occurs and operation commences, the
project will have sufficient cash to repay its debt service and
operating expenses, even though the project fails to meet
adequately performance requirements for any reasons;
6
Nevitt, Peter K., Project Financing: Fourth Edition, London: Euromoney Publications, 1983.
22
o Assurances by financially responsible parties that, in the event of
operation disruption, the necessary funds will be available to
restore the project to operating condition.
The critical distinguishing feature of a project financing is that the project is
a distinct legal entity. As a result, project assets, project-related contracts, and
project cash flow are segregated to a substantial degree from the project
sponsors. Such a financing structure is designed to allocate financial returns and
risks more efficiently than a conventional financing structure.
If lenders agree to look initially to project cash flow to make their credit analysis,
such an analysis does not mean that all the risks associated with the project
must be borne by the lenders. Most of these project risks need to be distributed
and assumed by various creditworthy parties. Consequently, project financing
does not imply that lenders assume all project risks. Actually, different credit
support mechanisms are necessary to make a project bankable on a project
finance basis.
According to Nevitt (1989), project financing implies the designing of the
financing of a project with the least degree of recourse to the project sponsors as
is possible, while at the same time securing enough credit enhancement from
such sponsors or any other interested third party, in a way that the lenders would
not assume a significant exposure to project risks. Finally, project financing
consists of distributing the different risks associated with a project to the various
participants who have a particular interest in the success of the project. This
23
distribution has to be done in such a way that each participant assumes a portion
of project risks that it is best able to manage. No precise procedure exists to
identify, evaluate, distribute, and neutralize project risks. That is why project
financing is a risky business.
2.3
Reasons for Private-sector Participation
There are several reasons for the private-sector participation of
infrastructure development7 . For example, in the emerging economies of Asia,
the main reason for including the private-sector in infrastructure development is
the scarcity of governmental resources to finance the infrastructure needs that
support economic growth. In Latin America, the reasons for private-sector
participation also include reduction of the impact on public finances of utility
company deficits, political pressure from society due to low quality and poor
coverage of services, and the need for funds to finance economic development
programs and to meet social requirements. In this region, some countries have
completed the first stage of including private-sector participation in the
development of the infrastructures. For these countries, the reasons of
continuous private-sector participation include the creation of investment
opportunities for the private sector, the inflow of capital and imported
7
This section is based on Vives, Antonio, "Private Infrastructure: Ten Commandments for
Sustainability," The Journal of Project Finance, Spring 1997.
24
technologies, and the development of capital markets, which have become more
efficient.
For developed countries, the main motivation appears to be reduction in
the cost of services and enhancement to technologies through competition
between private-sector suppliers. In certain cases, such as Spain and other
European countries, the need to meet the goals of the Maastricht Treaty (publicsector deficit reduction) requires the reduction of public investment without
jeopardizing economic growth.
2.4
Uses of Project Finance
The project financing technique has been extensively used for
infrastructure developments in many parts of the globe. In emerging markets,
where the needs for communication, transportation, housing, water, waste
treatment, and power generation are still growing, project finance provides a
financing scheme for important development. In countries moving from
centralized to market-based economies, project finance provides the necessary
financing to maintain, upgrade, and replace existing infrastructure assets.
Nevertheless, the use of project finance has not been restricted to infrastructure
investments in developing countries. Indeed, over 45% of the number of project
25
finance transactions worldwide reported in 1997 took place in Europe (33%) and
in North America (12%)8.
Projects financed using this technique tend to be large in scale, requiring
extensive capital. There are two reasons explaining this trend. First, economies
of scale can be achieved in both development and operation of the project
facility. Second, the massive needs for infrastructure development are to be met
by developing very large projects.
Project financing has long been used to fund large-scale natural resource
projects, such as Coso Geothermal Project (United States), Hamersley Iron Ore
Project (Australia), or Reserve Mining Project (United States). One of the more
notable of these projects is the Trans Alaska Pipeline System (TAPS) Project,
which was developed between 1969 and 1977. TAPS 9 was a joint venture of
eight of the world's largest oil companies. This project involved the construction
of an 800-mile pipeline, at a cost of $7.7 billion, to transport crude oil and natural
gas liquids from the North Slope of Alaska to the port of Valdez in Southern
Alaska. TAPS involved a greater capital commitment than all the other pipelines
previously built in the continental United States combined. This project is notable
by its huge capital investment and the technical challenges caused by the
stringent environmental conditions encountered.
8
Source: Capital DATA Project Finance Ware.
9 Finnerty, John D., Project Financing: Asset-Based Financial Engineering, New York: John Wiley
& Sons, Inc., 1996.
26
More recently, in 1988, five major oil and gas companies formed Hibernia
Oil Field Partners to develop a major oil field off the coast of Newfoundland. This
project involved $4.1 billion of development costs. Crude oil production
commenced in November 1997, and peak production, originally forecasted to
average 135,000 barrels per day, is now expected to hit 180,000 barrels per day
in 2000. The project was too large and too risky for any of the sponsors to
undertake on its own. The financial support of the Canada Federal Government
and Newfoundland Provincial Government was crucial to launching the project.
This project is a good example of using a public-private partnership to finance a
large project.
In the United States, the passage of the Public Utility Regulatory Power
Act (PURPA) in 1978 provided a major stimulus to the use of project finance.
Under PURPA, local electric utility companies are required to purchase all the
electric output from any independent power producers under long-term contracts.
This provision of PURPA encouraged the formation of stand-alone power
producers able to borrow large sums on the basis of the long-term power
purchase agreements they had entered into with electric utility companies.
These long-term contractual obligations were sufficiently sound to support
nonrecourse project financing. As a result, the growth of the independent power
industry in the United States can be attributed directly to passage of PURPA.
Such projects did not directly involve the public-sector participation, but
encouraged the development of private-sector initiatives.
27
In the United Kingdom, by contrast, the government has been directly
involved in a growing of infrastructure projects since it announced in 1992 the
establishment of the Private Finance Initiative (PFI). The PFI was designed to
involve the private sector in the financing and the management of infrastructure
and other projects. Project finance has been used principally for transportation
projects, such as the E320 million rail link to Heathrow airport, the E2.7 billion
Channel Tunnel Rail Link, and a £250 million project to build and operate a new
air traffic control center in Scotland. The scope of the PFI is not restricted to
transportation projects and the government has broadened its use to the
construction and the maintenance of prisons and hospitals.
Project financing for manufacturing facilities is another area in which project
financing has recently begun to develop.
2.5
Limited-recourse Project Finance Structures
According to Hoffman (1989), the term "project financing" is generally
used to refer to a nonrecourse or a limited-recourse financing structure in which
debt, equity, and credit enhancement are combined for the construction and
operation of a particular facility in a capital-intensive industry.
In a project financing nonrecourse structure, lenders base credit
appraisals on the projected revenues from the operation of the project,
independently of the credit of the project sponsor. Because the project debt is
nonrecourse against the project sponsor's assets, the project sponsor has no
28
direct legal obligation to repay the project debt or make interest payments if the
project fails to service its debt. As a result, lenders who lend to the project
company on a nonrecourse basis are very cautious about ways of the project
company entering into contract with the other project participants. Indeed, the
project contracts form the framework for project success and debt repayment.
The nonrecourse project financing technique, which results in no liability to
the project sponsor for the project debt, is rarely encountered. In most project
finance transactions, lenders require that assurances be put in place to arrange
sufficient credit support for project debt securities. This is accomplished through
contractual obligations provided by the project sponsors or other creditworthy
parties involved with the project. Such contractual arrangements generally
provide lenders with assurances that (1) the project will be completed even if
costs exceed those originally projected, (2) the project will generate sufficient
cash flow to meet all its debt service obligations, and (3) the project will continue
to service its debt obligations even if the project's operations are interrupted or
terminated for any reason. That financing structure is called limited-recourse
project financing. So, this technique is mainly characterized by allowing lenders
to impose obligations on the project sponsor to guarantee the repayment of the
project debt if the project revenues are insufficient to cover principal and interest
payments. This method has been used in recent years to finance major capitalintensive projects. Limited-recourse financing techniques include various
structures, such as BOT (Build Operate Transfer), BOO (Build Own Operate),
BOOT (Build Own Operate Transfer) and leasing transactions.
29
2.6
Advantages and Disadvantages of Project Financing
Project financing is often used by established, well-capitalized companies
that want to undertake projects required large debt commitments with a minimum
of risk. Project sponsors rely on project financing to develop projects in different
geographic areas because primarily each project is based on its own projected
cash flow that is independent of the financial obligations of the other projects and
required minimal equity contributions. There are others factors that explain the
attractiveness of project finance as a technique to finance large capital-intensive
projects around the world.
According to Buljevich and Park (1999), project financing is usually
chosen by project sponsors in order to:
Li
Eliminate or reduce the lender's recourse to the project sponsors;
Li Permit an off-balance sheet treatment of the project debt financing;
i
Maximize the leverage of debt avoiding dilution of existing equity;
Li
Avoid any restrictive covenants in other securities arrangements
that would otherwise preclude project development;
i
Avoid any negative impact of a project on the credit standing of the
project sponsors;
Li
Obtain better financial conditions when the credit risk of the project
is better than the credit standing of the project sponsors;
Li
Allow the lenders to appraise the project on a segregated and
stand-alone basis;
30
L Obtain better tax treatment for the benefit of the project, the
sponsors or both;
Li
Reduce political risks affecting the project.
Another reason for choosing the project finance technique is that it also
eliminates agency costs. Some of these reasons are discussed in more detail
below.
Nonrecourse or Limited-recourse Financinq:
Limited liability is usually the main reason for project developers for
undertaking a project finance transaction. Indeed, such a financing structure
allows project sponsors to limit, or remove in case of nonrecourse structure, their
obligations to the debt financing of the project company if the revenue generated
by the project is not sufficient to cover principal and interest payments.
Off-balance Sheet Treatment:
The off-balance sheet treatment of the project liabilities is another
important advantage of project financing. In a project financing, the debt of a
project is only included on the financial statements of the project company, and
therefore does not affect the sponsor's financial performance. However, in order
to benefit from an off-balance sheet treatment, none of the sponsors has to
control the project company. Control means ordinarily to own more than a 50%
31
participation in the capital of the project company. Exact accounting treatment of
debt financing of the project company is presented in more detail in Chapter 3.
Hiqhly-leveraqed Debt Financing:
Another advantage of project financing is that it permits to finance a
project using highly-leveraged debt reducing the amount of equity necessary for
financing the project. Debt-to-equity ratios in project finance structures vary from
project to project, but 70% or more are commonly accepted. However, lenders
generally require that the sponsors contribute a reasonable amount of equity to
the project company to ensure appropriate project sponsors' dedication to the
project success. The more equity contributed by the project sponsors, the less
temptation of abandoning the project prematurely.
Avoidance of Restrictive Covenants:
A fourth reason for selecting a project financing is that the structure
permits the project sponsors to undertake new capital-intensive investments
avoiding restrictive covenants. These restrictive covenants may consist of
restrictions on issuing new debt securities, limitations on new capital expenditure
or on participation in new ventures, and restrictions based on certain financial
ratios, such as interest coverage ratio, liquidity ratios and debt-to-equity ratio.
The distinct nature of the project financed permits the project sponsors to
leverage debt to an extent that may be prohibited under existing arrangements.
Similarly, existing covenants do not typically reach to the project financing.
32
Project Isolation:
By means of a project financing structure, the credit standing of the
sponsors is not affected by the financial risks associated with the development of
a project. Consequently, the project sponsors may undertake large and highly
risky projects without deteriorating their overall credit standing. Moreover, the
risk allocation in a project finance transaction allows project sponsors to assume
limited risks knowing that the failure of one of those projects will not cause their
bankruptcy. On the other hand, the credit risk of a project may be sometimes
better than the one of its sponsors resulting in more favorable interest rates and
lower credit enhancement costs.
Isolation of a project also has benefits for lenders. It permits lenders to appraise
a project on a stand-alone basis and to control project's operations on an isolated
basis without having to take into account the overall project sponsors' assets.
Tax Treatment:
The determination of the best form of business organization for a project
finance transaction is generally based on the idea of maximizing the tax benefits
for the project company, the sponsors or both. In fact, the type of legal structure
selected to form the project company may affect not only the tax treatment of the
project in the host country, but also the tax treatment of the sponsors and lenders
in their respective countries. Tax treatment is deeply discussed in Chapter 3 for
the most common forms of business organization used to structure a project
finance transaction.
33
Political Risk Diversification:
Political risk associated with the development and operation of a project
may be reduced by the involvement of various participants. Indeed, the host
country government could be reluctant to take action against the project since it
knows that it will have to face pressure not only from the project sponsors but
also from various project participants, such as multilateral agencies.
Project financing also has disadvantages. According to Hoffman (1998),
project financing presents several disadvantages, such as, among others:
u
Long and complex structuring process and risk allocation;
i
High degree of risk for lenders;
u
Higher financial costs than conventional financing;
u
Greater lender supervision on management and operation of the
project;
u
Expensive insurance coverage.
Project finance transactions are complex transactions involving many
participants with diverse interests. The identification and allocation of project
risks, which must be allocated carefully among project participants, result in long
negotiations and increased transaction costs. Moreover, the complexity of this
risk allocation process, which is a critical step for project success, may be
perceived as a high entry barrier in the project finance world.
34
The project financing structure also increases the degree of risk for the lender
since its recourse to the project sponsors is limited in case of default of the
project company to repay its debt. As a result, interest rates may be higher than
those ordinarily made directly to the project sponsors. However, this is not
always true because interest rates vary with market conditions.
Another disadvantage of project financing is the greater supervision lenders will
exercise on the management and operation of the project. Such supervision
results in higher costs that are typically borne by the project sponsors.
Nevertheless, many project developers have chosen the project finance
technique as it has often provided more flexibility to make large capital-intensive
projects successful.
35
3 Project Finance Ownership Structures
3.1
Project Finance Participants, Their Roles and Objectives
There are numerous parties involved in a typical project finance
transaction. Besides the project company and the lenders, these parties
generally include one or more project sponsors, suppliers, output purchasers,
one or more construction companies, one operator, and a host government.
These parties have different roles and objectives that may not be compatible.
3.1.1
Project Company
The project company is the entity that will own, develop, construct,
operate, and maintain the project. The determination of the best type of
ownership structure to undertake the project is usually dependent upon a myriad
of factors, such as proportion of debt and equity investments, tax and accounting
considerations, and legal and regulatory issues. The local law of the country in
which the project takes place is one of the major concerns in the selection of the
form of organization for the project company. For example, the local law can
prescribe a certain form of organization, prevent the project company from
owning real property in the host country, or require local investor participation in
36
the project company. The selection of the appropriate ownership structure for
the project (e.g., corporation, general partnership, limited partnership, joint
venture, limited-liability company, trust, etc.) is an important step in project
development. Some of the most frequently forms of business organization
chosen to undertake a project are discussed in more detail in this chapter.
3.1.2 Project Sponsors
The project sponsor generally consists of one or more corporations that
have special interests in the development of the project. Typically, project
sponsors are involved in either the construction or the management of the project
or both. Buljevich and Park (1999) provided a list of potential project sponsors,
which may consist of:
u A company interested in the construction and procurement of the
project facilities;
Li
A company interested in the operation of the project facilities;
i
A supplier of raw materials, fuel, or other inputs to the project;
L A purchaser of the project outputs;
Li
Passive institutional investors willing to make a capital investment
offering an acceptable rate of return;
L Financial institutions interested in being appointed as financial
advisors for the project and in structuring its debt financing.
37
In most cases, the equity of the project company is owned by the project
sponsors or by special-purpose corporate subsidiaries of each of them, which act
as a link between the respective sponsor and the project company. In some
cases, project sponsors may jointly create a special-purpose entity designated to
hold all the equity of the project company for purposes of making the sponsors'
relationships with the project company easier and for bringing more flexibility for
the entry of new equity investors in the project.
Other equity-holders may be companies with commercial ties to the project, such
as suppliers and project output purchasers, institutional investors, or financial
institutions. For example, in infrastructure project finance, the main shareholder
of the project company typically is the main constructor of the project facility.
Sometimes, the equity ownership of the project company include partners from
the country in which the project is located as a way of providing local
management and also as a way of reducing political risks by easing the relations
with the host government. In certain strategic areas, such as natural resources
and public services, local partners can be imposed by law.
When entering into project financing, the project sponsor seeks to reach
several objectives at once. The project sponsor primarily wants to undertake the
project "off-balance sheet" so that the project will not impact its overall credit
performance and its leverage. The project sponsor also looks at making a good
return on its investment in the project, and consequently seeks to retain control of
the project as long as possible to protect its investment and ensure its
38
profitability. The project sponsor often cannot carry all the risk itself, and
therefore seeks to share the risk with the other project participants.
3.1.3 Commercial Lenders
Commercial lenders, including banks, insurance companies, credit
corporations, provide debt financing for the project. These institutions may be
based in the host country or in another country. Sometimes, the lenders are
strategically selected from a range of countries. The purpose of this syndicate
diversity is to discourage the host government from taking actions against the
project, such as expropriation or changes in law. If the host government acted
against the interests of the project, it could bear economic consequences from
the home country of each lender. Sometimes the lending group includes lenders
from the host country to protect sponsors' interests. This association with
lenders in the host country tends to prevent the host government from penalizing
the project company. If the host government acted against the project, the
project company could not pay its debt service, and therefore local lenders could
lose their investments in the project. This consequence may be strong enough to
restrain the host government from discriminatory against the project.
The lenders may provide different types of debt to the project. These different
instruments for debt financing can be divided into either senior debt or
subordinated debt. The subordinated debt typically is junior in liquidation and
current payment to the senior debt but ranks senior to the equity and, therefore
39
principal and interest on subordinated debt are payable before dividend
payments. Senior debt financing typically is provided by commercial lenders.
Lenders generally are organized in syndicate to provide debt financing for
intensive-capital project investments. In this case, this association of several
lenders is the unique way of providing the project with the amount of debt
required. This situation is typical for infrastructure projects that involve
substantial investments. Furthermore, any one lender does not have the
capacity to provide the entire project loan and wants to limit its exposure to
financial risk.
3.1.4 Multilateral Agencies
The World Bank, the International Finance Corporation, regional
development banks and other international agencies provide significant credit
support for project finance transactions in developing countries. For example,
the role of the International Finance Corporation 0 (IFC) is to promote growth in
the developing world by financing private sector investments and providing
technical assistance and advice to governments and businesses. In partnership
with private investors, IFC provides both loan and equity finance for business
ventures in developing countries.
10 The IFC official mission statement can be found at http://www.worldbank.org.
40
The role of multilateral agencies is multiple but seeks mainly to support economic
growth in developing countries by providing to private investors funds required to
complete the financing and an insurance against political risk.
3.1.5 Suppliers
Once the project facility has been built and has become operational, the
project company will need to purchase the supplies necessary for the start-up
and operation of the project. Consequently, the project company enters with one
or more suppliers into long-term supply agreements for the provision of such
supplies. The suppliers may provide a broad type of supplies, such as raw
materials, gas, coal, fuel or other inputs to the project. Supply agreements
provide certainty in respect of the availability and the price of key supplies
required to produce and deliver the project outputs. Because of the importance
of inputs to the project, the project sponsors and the lenders are concerned with
the economic terms of the supply agreements and the ability of the suppliers to
provide the supplies necessary to the project in accordance with these
agreements.
A supplier of the project's inputs is interested in obtaining a long-term agreement
at the highest possible price with the project company.
41
3.1.6 Output Purchasers
In most capital-intensive projects, the project company usually enters with
a governmental entity or a private-sector company (the "off-taker") into a longterm sale and purchase contract in respect of the project outputs. The off-taker
or output purchaser is the purchaser of all or at least some of the products or
services produced by the project. The off-taker agrees to buy from the project
company a certain quantity and quality of project output, for a certain period of
time and at certain pre-established prices.
In most nonrecourse and limited recourse project finance transactions, the offtake purchaser provides the credit support for the underlying financing. Indeed,
an off-take agreement provides certainty that a project will generate sufficient
cash flow to service its debt and operating costs since the off-taker purchaser
commits itself to buy from the project company a certain quantity of project
output, for a certain period of time and at certain arranged prices.
3.1.7 Contractor
The contractor is the entity responsible for the construction phase of the
project. The design, engineering, construction, and the procurement of the
project facility are usually contracted by the project company with the contractor.
The contractor generally undertakes to build and deliver the project facility on a
turnkey contract basis. The terms of such a contract impel the contractor to
42
complete the project facility at a certain pre-determined fixed prices, by a certain
date, and in accordance with certain specifications and performance warranties.
Consequently, a turnkey construction contract typically provides engineering,
procurement, and construction services to complete the project facility and
deliver it to the project company in order to start the project's operation.
3.1.8 Operator
The operator is the entity responsible for the operation, maintenance,
management, and repair of the project. Most of the time, the project company
delegates the operation, maintenance, and management of the project to a third
party under the terms of an operating and maintenance agreement. Outsourcing
is a way for the project sponsors, who do not have the necessary competencies
to operate the project facility, to ensure that the project will be operated,
managed, and maintained according to operating industry practices. Such a way
of operating a project facility also enables the project sponsors to use their own
resources to develop projects related more closely to their own businesses,
without precluding their chances to undertake profitable projects. In other cases,
it is the owners of the project company who fill the operator's role.
43
3.1.9 Host Government
The host government is the government of the country in which the project
is located. As such, the host government typically issues permits, licenses,
authorizations and concessions to the project company.
In some projects, the host government is one of the owners of the project or will
become the owner of the project at the end of the concession period, such as in
a build-operate-transfer (BOT) structure. In others, the project company retains
ownership of the project's assets as it is the case in a build-own-operate (BOO)
structure.
The host government typically provides the project company with a concession
for the construction and operation of the project. Its role can be extended to
others domains. In some project finance transactions, the host government
might be the borrower. The host government might also be involved as an offtake purchaser or as a supplier of raw materials or energetic resources.
In general, the host government may have one or more objectives in cooperating
in a project's development. Hoffman (1998) suggested the following ones:
u
Obtain a quick and efficient development of needed infrastructure
provided by the project;
Li Promote economic development;
Li
Satisfy multilateral agencies of its development success and
economic growth;
Li
Insure a proper, safe, and efficient operation of the project;
44
Li
Minimize use of its own fund or credit for economic growth;
a
Obtain project ownership after private participants receive an
agreed equity return;
Li
Take control of the project if it is inefficiently operated;
u
Limit restrictions on its ability to enact new laws and promulgate
new rules.
3.2
Project Finance Participants Structure
Figure 3.1 summarizes a typical project financing structure with some of the
major participants involved in a project finance transaction.
I .
Lenders
.pnsr
Suppliers]
Host
Government
/0000W
Off-ake
Purchaser
1E/M Equipment
I
ivil Works
Fig. 3.1: Project Finance Participants.
45
3.3
Selection of the Project Finance Ownership Structure
Selection of the form of business organization for the project company is
an important step in project development. The type of form of organization
selected by the project sponsors can have significant impacts on project
development and on its financing. For example, transfer of the ownership of the
project can be prohibited in some jurisdictions. Therefore, the project company,
independently of its form of organization, should be organized in the early stages
of the project developments to avoid these kinds of concerns.
The appropriate ownership structure for a project depends on a variety of
business, legal, accounting, tax, and regulatory factors. According to Finnerty
(1996), the following factors have to be considered in selecting the form of
business organization for the project company:
u
The number of participants and the business objectives of each;
u
The project's cost of capital and the anticipated earnings pattern of
the project;
u
The requirements of the regulatory framework;
Li
The existing debt instruments and the tax positions of the
participants;
Li
The political jurisdiction in which the project is located.
The last factor raises the important question of where the project company
has to be organized. The project company could be organized either under the
46
laws of the host country or under the laws of the project sponsors' countries. As
a result, the project sponsors have to determine the advantages and
disadvantages of each country's laws and the tax treatment of the project
company in each country.
3.3.1
Basic Forms of Project Finance Ownership Structures
While most companies prefer absolute ownership and control of projects
they undertake, the formation of jointly owned projects is sometimes a solution
that has to be considered for certain projects that are beyond a single company's
financial and management resources. Indeed, a number of factors can render
such a jointly structure attractive, such as:
Li
The risks of the project are shared;
Li
The sponsor can benefit from an off-balance sheet financing by
using the project company as the borrowing entity, and in some
cases from tax deductions;
Li A greater debt leverage can be obtained.
There are basically four forms of business organization for jointly owned
projects: (1) corporations, (2) general partnerships, (3) limited partnerships, and
47
(4) joint ventures. This section" presents the forms of business organization
most frequently selected for undertaking a project. For each of the basic forms of
organization recorded, a financial analysis is presented through accounting and
tax considerations, and the reasons for selection are exposed.
3.3.2 Corporation
A corporation is probably the most common form of business organization
selected for structuring a project financing transaction. In this ownership
structure, the project sponsors incorporate an entity to develop, construct, own,
operate, and maintain the project. This corporation, which is frequently wholly
owned by the project sponsors, raises funds through the sponsors' equity
contributions and through the sale of debt securities directly issued by the
corporation. The corporation borrows on the basis of its own credit. Debt
securities issued by the corporation can take the form of either senior debt or
subordinated debt, including preferred stock or convertible securities.
11 This section is based on Finnerty, John D., Project Financing: Asset-Based Financial
Engineering, New York: John Wiley & Sons, Inc., 1996, Chapter 5 and Nevitt, Peter K., Project
Financing: Fourth Edition, London: Euromoney Publications, 1983, Chapter 8.
48
Accounting Considerations:
The impact a project has on the financial statements of a project sponsor
depends principally on its percentage of ownership of the project corporation.
Accounting rules in the Unites States1 2 require line-by-line consolidation of assets
and liabilities for financial accounting purposes if an entity controls another entity.
Control normally means ownership of more than a 50% voting interest. As a
result, if a sponsor owns more than 50% of project equity, full consolidation is
required. In that situation, the sponsor must consolidate the project's financial
statements on a line-by-line basis. Such consolidation on a line-by-line basis can
adversely affect the financial performance of the sponsor. Typically, the debt-toequity ratio will increase, and therefore the coverage interest ratio13 will fall down
eroding the project sponsor's ability to meet its annual debt payments.
Consequently, the financial burden the project sponsor has to face increases.
On the other hand, ownership of 50% or less of a project corporation is generally
insufficient to achieve control of the project corporation, and in such case the
project sponsor can employ the "equity method" of accounting. Under equity
accounting, a sponsor carries ownership interest in the project on its own
balance sheet as an investment, and reports its proportionate share of project
income or loss. Project assets and liabilities in that case are not included on the
project sponsor's balance sheet, and only a one-line entry is required on the
1
Accounting rules referred to Accounting Research Bulletin No. 51 (ARB 51) and Accounting
Principles Board Opinion No. 18 (APB 18).
13
This ratio compares income available for debt service to annual interest obligation.
49
profit and loss statement. In that case, the performance ratios of the project
sponsor are preserved.
If a project sponsor owns less than 20% of project equity, no disclosure is
generally required by law. Nevertheless, the project sponsor normally has to
disclose in a footnote any contingent liabilities with respect to the project. The
project sponsor will normally account for its investment in the project corporation
under the "cost method." Under this method, the equity contribution is carried as
an investment at original costs, and the sponsor reports project income only to
the extent it received dividends from the project corporation. Project assets and
liabilities are not included on the sponsor's balance sheet. Table 3.1 summarizes
project sponsors' accounting treatment for equity investment.
Project Sponsors'
Accounting Treatment
for Equity Investment
L
Li
i
Sponsor Percentage Ownership of Project Corporation
50% - 100%
20% - 50%
0% - 20%
Li "equity method" is L Full consolidation
"cost method" is
is required on a
generally used
generally used
line-by-line basis
project assets and Li project assets and
liabilities are not
liabilities are not
included on the
included on the
project sponsors'
project sponsors'
balance sheet
balance sheet
L a one-line entry is
only dividends
required on the
from the project
profit and loss
corporation are
statement
reported
Table 3.1: Accounting considerations relative to percentage ownership of project corporation.
Tax Considerations:
A project corporation is considered as a separate taxable entity and files
its own income tax return. Assuming that no single participant owns sufficient
equity to consolidate the project on its own financial statements, the tax benefits
50
of ownership arising out of the project, such as investments tax credit,
depreciation and interest deductions are available to the project corporation.
Only the project corporation is entitled to benefit from these tax deductions.
Nevertheless, such tax benefits are deferred if the project corporation has
operating losses. These deductions must be carried forward for many years until
the project corporation is taxable.
As mentioned earlier, the project corporation is recognized as a taxable entity.
As a result, the project's income is exposed to two levels of taxation, in the
absence of consolidation. The "double taxation" of the project earnings occurs
when the project corporation pays dividends since the dividends received from
the project corporation are subject to income taxes at each sponsor's applicable
income tax rate.
A typical jointly owned project corporation structure is illustrated in Figure 3.2.
C,)
Stock (X%) and
Subordinated Loans
0
Constructio
Company
and
5ub-olditite Lijigm
Stock (Y%)
Stock (Z%) and
Subordinated Loans:
XYZ
Project
I&ML-M "
U
z
uTerm
LendersCopn
Fig. 3.2: Ownership Structure when a project is organized as a Corporation jointly owned by
several project sponsors. Adapted from Nevitt, Peter K.
51
Advantages:
The corporate form of organization offers the advantages of limited liability
and the benefits associated with the creation of a separate legal entity.
The formation of a new entity to undertake a project allows the owners of the
project corporation to enjoy limited liability for the actions of the corporation.
However, a loss of this liability protection, called a piercing of corporate veil, can
occur where the corporate identity of the special-purpose subsidiary created by
the project sponsors for purpose of undertaking the project is disregarded. To
avoid the piercing doctrine to be applied in a project financing, the subsidiary
should (1) have a valid business purpose in close relation to the development of
the project, (2) be managed by representatives of the corporation rather than
those of the parent company, and (3) be identified as the contracting party.
Beyond the limited liability, which insulates the project sponsors from all the
obligations of the corporation, the advantages related to the fact that the project
corporation is recognized as a separate legal and taxable entity are as many
reasons for adopting the corporate form of structure to organize the project.
These advantages for the project sponsors are the following ones:
u
Debt of the project corporation is off-balance sheet for the project
sponsors if they own less than 50% of the project ownership;
Li
Project sponsors' performance ratios are not directly affected,
hence their ability to raise funds for other projects is preserved;
i
Li
Project sponsors' loan covenants are not affected;
Capital is preserved for undertaking other investments;
52
u
Loans are non-recourse to the project sponsors.
Disadvantages:
Nevertheless, the corporate form of organization has some disadvantages
that the project sponsors must take into account. The project sponsors usually
do not receive immediate tax deductions from any investment tax credit the
project corporation can claim or from possible operating losses of the project. On
the other hand, the ability of a project sponsor to invest in the project corporation
may be limited by provisions contained in loan agreements which may restrict
permitted investments. Finally, the borrowing cost could be higher since the debt
leverage of the project corporation may be greater than that of the project
sponsor.
3.3.3 General Partnership
The partnership form of organization is frequently used in structuring joint
venture projects. Each sponsor, either directly or through a wholly owned
subsidiary, becomes a partner in a partnership that is formed to own and operate
the project. Under the terms of a partnership agreement, all partners agree to
share proportionately in management and income of the project undertaken. The
partnership can enter into financing arrangements in its own name. As a result,
the partnership issues securities, either directly or through a corporate borrowing
vehicle, to arrange the financing of the project.
53
A partnership form of organization is particularly attractive for projects in which
project sponsors agree to take the project's output in proportion to their share
ownership as a direct source of revenue. Such projects are called "cost
companies." In that case, the Internal Revenue Code authorizes to pass through
tax benefits of ownership to the project sponsors. Costs companies have been
extensively used in mining projects.
General partners generally are jointly and severally responsible for all
obligations of the partnership. These liabilities include contracts, debt, and tort
liabilities. Potential tort liabilities can usually be covered by insurance. In theory,
the extent of a general partner's potential liability could exceed its reported
balance sheet liabilities if one of the general partners were to act improperly.
Limited partnerships, which are described below, avoid this liability problem.
The exposure of the project sponsors to project liability, however, can be reduced
in different ways. Partners can protect themselves to some extent by forming
subsidiaries to enter into a partnership agreement to operate a joint venture
project. However, there is some risk associated with this solution. A court might,
in the future, "pierce the corporate veil" and impose liability on the parent
company. Nevertheless, this risk can be mitigated if the corporate subsidiary has
a valid business purpose related to the project. Further steps can be taken to
protect project sponsors who wish to operate a project as a general partnership.
One such step is to limit lender recourse to the assets of the partnership and
require lenders to waive rights against the assets of each partner. Lenders will
accept such arrangements with the partners only if the assets of the partnership
54
are strong enough to support the transaction. Such assets may include, for
example, an unconditional take-or-pay contract. Indeed, such a contract, which
gives the owner assurance that it will have sufficient cash flow to meet operating
expenses and debt service, provides lenders with strong credit support. Another
step is agreements among the partners not to enter into loan agreements without
the consent of all partners.
Generally, the partners establish a separate project corporate entity, which is
owned by the partnership, to issue securities. This separate entity, created for
purpose of arranging the financing of the project, is known as a corporate
financing vehicle. In that borrowing structure, a partnership issues notes to the
corporate financing vehicle which, in turn, issues notes to project lenders. The
terms of the notes issued by the partnership are identical in interest rate and
maturities to those issued by the corporate financing vehicle. The terms of the
partnership notes normally preclude recourse to the general credit of the
partners. As a result, project lenders look solely to the projected revenues of the
project as the main source of repayment of their loans.
Accounting Considerations:
Financial accounting for partners in reporting liabilities of partnership
follows the same rules as for corporation providing that recourse for partnership
liabilities is limited to partnership assets. If a partner owns more than 50% of
partnership equity, full consolidation is normally required on a line-by-line basis.
Less than 50% of partnership equity but more than 20% generally requires only a
55
one-line entry of the partners' investment. Each partner normally accounts for its
equity investment under the equity method. As a result, each partner reports in
its own income statement its pro rata share of project income or loss. Project
assets and liabilities are not included on its balance sheet.
Tax Considerations:
A partnership is not a separate taxable entity, does not pay income tax,
and files a partnership income tax return, which reports the revenues,
deductions, and credits attributable to the partnership. Unlike a corporation, the
net income or loss of the partnership is passed through to the partners. Each
partner does not reflect project assets and liabilities on its balance sheet but
includes in its own tax return its proportionate share of partnership income or
loss. Thus, each partner benefits from tax deductions, operating expenses,
investment tax credit, and interest deductions. The use of a wholly owned
corporate subsidiary to serve as one of the general partners does not preclude
the project sponsor to claim these tax deductions as long as the subsidiary is
consolidated for income tax purposes. Nevertheless, a partner may deduct
partnership losses only to the extent of its tax basis in its investment in the
partnership.
If the partnership structure is selected, care must be taken that, in limiting the
functions of the partnership, the resulting entity for tax purposes does not have
56
too many corporate characteristics. Generally 1 4 , two of the following four
attributes must be present for a partnership form of organization to be
characterized as an association, which is taxed as a corporation: unlimited life,
centralized management, free transferability of ownership, limited liability for all
owners. Normally, it is possible to form a partnership that will be not
characterized as an association, even if protective steps are taken to limit the
exposure of the partners' liability, by avoiding free transferability and continuity of
life.
Figures 3.3 and 3.4 show partnership ownership structures when a project is
organized with or without using a corporate financing vehicle.
0IC
a)
uJ
CotribtioI
Capitl
Capital Contributions:
Conriuton
Capta
Z Ownership %
YOwesi
0
e shi
0
-
m
NEU=~
z
MN
LL
Fig. 3.3: Ownership Structure when a project is organized as a General Partnership. Adapted
from Nevitt.
14
This criterion is required by the Internal Revenue Service (IRS) to avoid taxation of the general
partnership as a corporation.
57
Ownership
10%Oneship
a_
Ul)
Lu
-S.
-praeS.biir
__
Y
X'7 Ownership
nrhip
_,
Z7 Ownership
0
100%7Ownership
0
is organized as a General Partnership using
OnrhpStructure when
Fig. 3.4: Oweshpproject
corporate subsidiaries and corporate financing vehicle. Adapted from Nevitt.
Advantages:
The partnership form of ownership is typically selected when (1) the
project sponsor does not have sufficient financial resources to pursue the project
in its own name, (2) all partners want to participate in project management and
control, or (3) all partners have similar tax positions.
Beyond these most common reasons, a project sponsor may see the following
advantages as sufficiently incentive to select the partnership of organization for
the project:
<
Debt of the partnership is off-balance sheet for the sponsor if less
than 50% owned;
F3 Economies of a large-scale project may be achieved by combining
financial resources and technical expertise of several partners;
58
"
The borrowing cost may be lower as a result of combining the
project with other partners;
"
Partners immediately can benefit from tax deductions and
investment tax credit.
Disadvantagqes:
Nevertheless, the partnership structure of ownership has disadvantages
that must be considered when the project sponsors have to select a form of
organization for a project they plan to develop. The general partnership structure
does not afford nonrecourse or limited-recourse liability. As a result, the partners
are jointly and severally liable for all the debts and obligations of the partnership.
Moreover, the loss of absolute control over the project can be seen as a limitation
for project sponsors.
3.3.4 Limited Partnership
A limited partnership form of organization is a business entity that
expressly limits the liability of the limited partners to the extent of their capital
contributions in the limited partnership. Nevertheless, limited partners can claim
a proportionate share of tax deductions from the operation of the partnership.
Limited partners and general partners in a limited partnership may be either
individuals or corporations.
59
Limited partnership must always have at least one general partner. The general
partner is liable for all the debts and obligations of the limited partnership but can
mitigate its exposure by using the different techniques previously described.
Limited partnerships have been used extensively to finance the development of
oil and gas fields. Limited partnerships have been also used in financing real
estate.
In structuring a limited partnership, care must be taken to meet the Internal
Revenue Service criteria as previously described for general partnership. It is
generally fairly easy to structure a limited partnership so as to avoid free
transferability, limited liability, and continuity of life.
Under a limited partnership structure, each limited partner shares in the project
profits while enjoying the associated limitation liability. The partners exercise
minimal management rights since the exercise of such rights can transform their
limited liability to general liability.
Accounting and tax considerations are similar to those enumerated for
general partnership form of organization.
Figure 3.5 shows a typical ownership structure when a project is
organized as a limited partnership.
60
100% Ownership
100% Ownership
LU
X
Corporate Subsidiary
Share Ownership
Special-Purpose
asGnrlate
Corporation
Formed
Limited
Partnership
Interest
0
Share Ownership
tSev
General
Partnershi p
Interest
Limited
Partnership
Interest
Z
Passive Equity
Investors
<
Fig. 3.5: Ownership Structure when a project is organized as a Limited Partnership. Adapted
from Nevitt.
Advantaqes:
A limited partnership is similar to a general partnership, except that it has
both general partners and limited partners. While a general partner is liable for
all the debts and obligations of the limited partnership, liability of the limited
partners is limited to the amount of their capital investments. Because of this
limitation of liability available for the limited partners, the limited partnership
structure is a useful form of organization for passive equity investors. Such a
structure is sometimes used for the participation of contractors or equipment
suppliers to project equity. These participants advance capital to the project to
ensure that the project financing is arranged so that return on their investment is
realized.
Beyond the main reason that the limited liability offers to the project sponsors,
the partnership form is generally selected because it provides the partners with
the following advantages:
61
L Tax benefits are normally flow through to the partners in same
proportion as their ownership percentage;
Li
Project assets and liabilities are not included on the project
sponsors' balance sheet if they own less than 50% of the project;
"
Project sponsors' performance ratios are not affected, neither do
their loan covenants;
"
Access to new source of funds is provided.
Disadvantages:
Nevertheless, the project sponsors, before selecting the limited
partnership structure, have to become aware of some of the restrictions tied to
this type of form of organization. The loss of some control over facilities or
service functions, and the time and legal expenses associated with the
arrangement of the financing can prevent the project sponsors from selecting the
limited partnership as the most efficient structure to organize the project.
3.3.5 Joint Venture
There are two types of joint ventures: equity joint ventures and contract
joint ventures. Equity joint ventures typically involve the formation of a separate
entity, such as a partnership or a corporation. Contract joint ventures, by
contrast, do not usually require the creation of a separate legal entity.
62
After a description of what a contract joint venture is, one of the common joint
venture ownership structures known as undivided joint interest is presented.
A contract joint venture used for structuring project finance is defined as a
combination of entities that agree by contracts to achieve a common purpose.
Joint venture closely resembles a partnership. However, there are some
differences that make a distinction between a joint venture and a partnership:
L Participants to a joint venture contract among themselves rather
than enter into a partnership agreement;
u
Partners may be jointly and severally liable beyond their
investment. Participants to joint venture are liable only to the extent
of their investment and advance to the project;
Li
Property of a partnership may be held in partnership name.
Property of a joint venture is held as tenants in common: each party
holds an undivided interest of the project;
u
The joint venture often has a fairly limited purpose and life, which
may be determined by the nature of the project itself.
When the project is organized, one of the participants with extensive
experience in the type of project that must be constructed and operated is
typically designated to serve as the manager, with the authority to act for the joint
venture. The participants also choose, by agreement, a party to act as the
operator of the joint venture. Although this party has some characteristics of a
63
general partner, the operator does not have the broad management control over
the project facility nor the general liability that define a general partner.
Contract joint ventures by their nature do not constitute legal entities that can
easily borrow for their own account. Funds are advanced as needed by each
participant in the joint venture.
Joint ventures have been used by electric and gas utility companies, and in the
development and operation of mines. For illustration, the figure 3.6 shows the
typical joint venture ownership structure used for the development and operation
of a mine.
CL
Operatin
W
Steel Company
Y
dr
Steel Company
Agreemen
(I)
cc
111
0
x
Steel Company
Z
Steel Company
Proec
Operator
Advances and
Contributions
to Capital
Advances and
Contributions
to Capital
Advances and
Contributions
to Capital
(D
z
Advances and
Contributions
Capital
10
Jon
-
-to
Lease
Agreements
Loan
Agreements
C)
z
z
Leasing
Comp~any
Fig. 3.6: Ownership Structure when a Project is organized as a Joint Venture for the development
and operation of a mine. Adapted from Nevitt.
64
Undivided Joint Interest:
Under the undivided joint interest ownership structure, each participant
owns an undivided interest in the project's assets, and shares in the benefits and
risks of the project in direct proportion to the ownership structure.
When the project is organized, the participants choose one of them to serve as
the project operator. This arrangement is particularly suitable when one of the
owners has operations in the same business. The duties of the project operator
and the obligations of all the parties involved in the project are specified in an
operating agreement. The project operator is responsible for maintaining a
record of capital expenditures and operating expenses, and for making the dayto-day operating decisions that determine the profitability of the project.
In general, each participant is required to assume responsibility for raising its
share of financing for the project. Each sponsor is free to do so by whatever
means are most appropriate to its financial positions.
The project entity could not issue debt securities on its own because it does not
have the legal standing to enter into a contract to repay its debt service. As a
result, the project sponsors are the financing entities. According to Finnerty
(1996), the undivided joint interest has particular appeal when firms sponsoring
the project are different credit rating. Indeed, by financing independently the
project, the higher-rated entity can borrow at a cost that is lower than the cost at
which the project entity can borrow, based on its composite credit structure. On
the other hand, depending on the sponsor's ability to take immediate advantage
of the tax deductions of ownership arising out of the project, direct co-ownership
65
may also provide the project sponsors with immediate cash flow to fund their own
equity investments.
However, under certain conditions, it may be preferable to create a separate
project entity to arrange the financing of the project. It could be the case when
the project's construction cost is large relative to each sponsor's total
capitalization. In that situation, the project-related financing obligation combined
with the normal financing requirements of ongoing businesses might exceed the
project sponsors' ability to repay its total debt service. Moreover, the additional
debt load might cause the deterioration of the sponsors' debt-to-equity and
interest coverage ratios. Such decline might result in lower bond ratings, and
therefore higher interest costs.
Accounting Considerations:
An undivided joint interest is not recognized as a separate entity for
accounting purposes. Each participant has to reflect its proportionate share of
project assets, revenues, and operating expenses in its own financial statements.
Any direct liabilities incurred by a co-owner to fund its share of the project's cost
appear on its own balance sheet.
Tax Considerations:
The Internal Revenue Service (IRS) generally considers that an undivided
joint interest form of business should be treated for tax purposes as a
partnership.
66
Project tax deductions arising from interest, depreciation, and investment
tax credit flow directly to the co-owners. This tax benefits treatment avoids
"double taxation" of the project income. Nevertheless, in some instances, the
IRS has deemed an undivided joint interest as an association, which is treated as
a corporation for tax purposes. Because of the disadvantages that arise from
being taxed as a corporation, the operating agreement must to be arranged so
that at least two of the following conditions be guaranteed:
Li
Management is not centralized but decisions are making jointly;
u
Ownership interests are not transferable without the consent of the
other sponsors;
i
At least one the sponsors must have direct exposure to project
liabilities;
Li
The joint venture terminates upon bankruptcy, resignation, or
expulsion of any sponsor.
A joint venture is typically selected for a project financing transaction when
a project sponsor does not have the financial or management resources to
undertake the project alone. The project sponsor joins with other entities to
achieve the project by combining financial resources and technical expertise, and
by sharing risks. Sometimes, the project sponsor may have all of the
qualifications, resources, and experience to develop the project itself, but lack of
political contacts in the country in which the project is located can prevent it from
undertaking the project. One alternative for the project sponsors is to combine
67
equity with local entities to develop, construct, own, and operate the project
through the creation of a joint venture. Other factors, among others, can weigh in
favor of a joint venture structure, such as efficient allocation of tax benefits,
avoidance of restrictive covenants in loan agreements, spreading of risk, and
lower borrowing cost.
3.4
Comparison of Alternative Forms of Organization for a Project
Table 3.2 summarizes the principal considerations associated with selecting the
appropriate form of organization for a project.
Ownership of Project
Assets
Operating
Characteristics:
L Management
Li
Sharing of project
costs and benefits
Corporation
Partnership
Project assets are
owned by the
corporation
Project assets are
owned by the
partnership.
The project
corporation operates
the project.
Employees of the
project corporation
manage the project.
The equity owners are
represented on the
project corporation's
board of directors.
The partnership
operates the project.
One of the general
partners is usually
designated the
manager of
partnership
operations. The
partnership
agreement specifies
operating and
management
authorities.
The partners enter
into a partnership
agreement, which
specifies their rights
Allocation is
determined by
contracts among the
project participants.
68
Joint Venture
(Undivided Joint
Interest)
All property
constituting the
project is owned
directly by the
participants as
tenants in common.
Co-owners appoint an
operator to manage
the project. Approval
by a steering
committee containing
representatives of all
the co-owners is often
required for major
decisions.
Project costs and
benefits are usually
allocated in the same
proportion as project
Participants' Liability
for Project
Obligations:
L Nature of liability
Li
Dollar amount of
exposure
Financing:
L General structure
L
Financing Vehicle
Participants'
Accounting Treatment
for Equity Investment:
Li Less than 20%
ownership and no
effective control
Li
Greater than 20%
and obligations.
Project costs and
benefits are allocated
in proportion to project
ownership.
ownership. Coowners enter into an
operating agreement,
which specifies their
rights and obligations.
General partners are
jointly and severally
liable for all the debts
and obligations of the
partnership. Limited
partners have no
liability for partnership
obligations except
obligations they
specifically undertake.
Liability unlimited for
general partners.
Liability limited to
equity invested for
limited partners
except as otherwise
agreed.
Operating agreement
normally provides that
any liabilities relating
to the co-tenancy will
be borne by the
project's co-owners in
proportion to their
respective ownership
percentages.
Equity funds are
contributed by
sponsors. The project
corporation issues
debt secured by a lien
on project assets and
the project
corporation's right to
receive payments
under various
contracts.
Project corporation or
a special-purpose
corporate subsidiary.
Sponsors provide
equity in the form of
partners' capital
contributions. The
partnership issues
debt secured by a lien
on project assets and
the project company's
right to receive
payments under
various contracts.
Special-purpose
corporate subsidiary
of the general
partnership.
Each co-owner is
responsible for
providing its pro rata
share of the capital
cost of the project
from its own financial
resources.
Equity investment
accounted for under
the "cost method."
Income recognized
only to the extent
dividends are
received. Project
assets and liabilities
are not included on
equity holder's
balance sheet.
Equity investment
Equity investment
accounted for under
the "cost method."
Income recognized
only to the extent
dividends are
received. Project
assets and liabilities
are not included on
equity holder's
balance sheet.
Equity investment
Equity owners have
no direct liability for
project obligations
except as specifically
defined in contractual
undertakings.
Liability limited to
equity contributions to
the project except as
otherwise agreed.
69
Unlimited liability.
Corporate subsidiary
of each co-owner.
Proportional
consolidation of
project assets,
revenues, and
expenses.
Proportional
and not over 50%
ownership and no
control
Li
Greater than 50%
ownership
Income Tax
Treatment:
Li Taxable entity
i Availability of
project
depreciation,
interest expenses,
and investment
tax credit to
sponsors
L Limitation on
project deductions
taken by
participants
L
Taxation of
project income
accounted for under
accounted for under
the "equity method."
the "equity method."
Pro rata share of
Pro rata share of
project income or loss
project income or loss
is recognized by
is recognized by
sponsor. Project
sponsor. Project
assets and liabilities
assets and liabilities
are not included on
on
included
are not
sponsor's balance
sponsor's balance
sheet.
sheet.
Full consolidation is
Full consolidation is
normally required on a normally required on a
line-by-line basis.
line-by-line basis.
consolidation of
project assets,
revenues, and
expenses.
Proportional
consolidation of
project assets,
revenues, and
expenses.
Project corporation.
Project affects taxable
income of sponsor
only to the extent of
dividends received
from the project.
Partners.
Tax benefits flow
through to partners in
same proportion as
ownership
percentages.
Co-owners.
All tax consequences
of project flow through
directly to the coowners.
Project deductions
may not be taken by
equity holders unless
consolidation is
permitted. No
limitation is tax
consolidation occurs.
Deductions (except
ITC) are normally
limited to the tax basis
of each partner's
investment.
No limitations.
Project income is
taxed at project
corporation level.
Dividends are also
taxable to equity
holders after 70%
dividends received
deduction.
Project income is
taxed at partner level
only.
Project income is
taxed at co-owner
level only.
Table. 3.2: Comparison of alternative forms of business organization for a project. Directly
adapted from Finnerty.
70
3.5
Public-Private Partnerships
Public-private partnerships are joint ventures in which the private sector
and government cooperate to develop a project more quickly and more
efficiently. Each participant uses its particular strengths to make the project
successful. Public-private partnership arrangements vary from full private
ownership subject to governmental approvals to public projects in which the
private partner provides capital and management services. This last structure
allows a government that uses project financing to fund a public-oriented project
to obtain both private-sector funding and private-sector management. Project
financing therefore is used by the government to reduce its need of borrowing,
shift part of the project risks to the private sector, and achieve more effective
management of the project. The government can also limit the private-sector
participation to only management services. In that case, the government
contracts with the private sector for providing management services while
continuing to finance the project and retaining ownership of the project assets.
So, the public-private partnership structure can take several forms. Table 3.315
presents the different means of involving the private sector in project
development.
15
Chew, Donald H.and Stern, Joel M., The Revolution in Corporate Finance: Third Edition,
Danvers, Massachusetts: Blackwell Publishers, 1997, pp. 225.
71
Arrangement
Project Finance
Privatization
Service Contracts
Leases
Nationalization
Management
Private Sector
Private Sector
Private Sector
Government
Government
Finance
Private Sector
Private Sector
Government
Private Sector
Government
Table 3.3: Private-sector participation in project development.
Private-sector involvement is increasing in many areas traditionally
developed and managed by the public sector. Transportation projects are very
attractive to private participation. For example, toll roads and bridges, airports,
and railways can often generate adequate financial rate of return to attract
private capital investment. Generally, if a transportation project or any
infrastructure project is associated with the possibility of generating revenues
from user fees, its development could potentially be insured by a public-private
partnership.
In recent year, infrastructure needs in the United States have grown more
rapidly than the available funding1 6. Many states have encouraged so far the
private-sector participation in the development, financing, operation, and
ownership of transportation facilities, such as toll roads or toll bridges by
arranging the legal framework.
Outside the United States, the needs for infrastructure development are still
growing but cannot be met with local funding. Infrastructure projects, particularly
in the emerging markets, have been financed using in some extent public funds
16
Financing the Future, Report of The Commission to Promote Investment in America's
Infrastructure, Washington, D.C.: U.S. Department of Transportation, February, 1993.
72
and private capital both supported by multilateral agencies, such as the World
Bank.
73
4 Project Finance Security Arrangements
4.1
Role of Security Arrangements in Project Finance
Security arrangements, which take the form of contractual agreements,
are primarily designed to allocate project risks and financial returns among the
different parties involved in a project. They are also designed to enable the
project company to extend its borrowing capacity. Indeed, an adequate set of
project contracts provide project lenders with guarantees of debt repayments
taking into account the credit support given by third parties interested in the
project development. For example, an off-take agreement enables the project
sponsors to support the debt financing by establishing whether the project will
generate sufficient cash flow.
" Project contracts are the foundation for the success of a project financing
and most of the issues relating to the structuring of a project finance transaction
are usually addressed by project contracts."" Therefore, project contracts play
the utmost important role in structuring a project finance transaction and ensuring
its success.
17
Buljevich, Esteban C. and Park, Yoon S., Project Financing and the International Financial
Markets, Boston: Kluwer Academics Publishers, 1999.
74
4.2
Project Agreements and Contracts1 8
The project company enters with project contractors into different project
contracts for the purposes of the development of the project. This section
presents some of the most important project contracts in a project finance
transaction.
4.2.1
Concession Agreement
The right to develop, own, construct, and operate a project is in general
granted by the host government in a concession agreement. A concession
agreement is entered into between the host government and the project
company or the project sponsors if the project company is not yet formed. A
typical concession agreement contains the following terms:
Li
Terms of the concession;
Li
Description of project company's rights;
La
Permissive equity structure for the project company;
Li
Management of the project company;
Li
Restrictions on foreign ownership and control of the project
company;
18
This section is based on Buljevich, Esteban C. and Park, Yoon S., Project Financing and the
International Financial Markets, Boston: Kluwer Academics Publishers, 1999, Chapter 8.
75
"
The manner by which the host government will be compensated for
granting the concession;
"
Applicability of tariffs and price controls to the project;
"
Default provisions by which the concession could be terminated;
Li
Termination procedure;
Li Concession renewal provisions.
The host government may require various protections given by the project
company in the concession agreement. These guarantees may include:
L Service requirements from the project company throughout the
concession term;
i
Sufficient operation and maintenance activities so that the project
facility, which is in general transferred to the host government at the
end of the concession period, retains value;
Li
Rights of the host government to terminate the concession if certain
events occur to the project company.
From the project company and lenders' perspective, the host government
also has to provide certain assurances. These assurances to the project
company and the project lenders may include:
L Assurances of availability of energetic resources;
"
Work visas for management;
"
Provision of necessary real estate rights;
76
Li Assurances against expropriation and nationalization of the project;
Li
Protections against change in law and currency convertibility.
4.2.2 Construction Contracts
The project company usually enters with one or more construction
companies and equipment suppliers into construction contracts for the purposes
of the design, engineering, construction, and procurement of the project facilities.
In general, construction contracts are turnkey contracts requiring the construction
company to build and deliver the project facilities at a certain predetermined fixed
price, by a certain date, and in accordance with certain specifications and
performance warranties.
A turnkey construction contract usually includes the following provisions:
u
A comprehensive description of the services to be performed by the
constructor, such as design and engineering services; procurement
of all materials and equipment; quality control; safety procedures
and personnel training; procurement of all relevant permits and
authorizations relating to the construction of the project and clean
up activities;
L A fixed-sum price, payable in installments upon achievement of
certain specific construction events;
Li
An undertaking by the constructor guaranteeing that the project
facility will be completed by a certain date, with liquidated damages
77
payable by the constructor for each day of delay to compensate the
project company for all costs associated with such delay;
u
A performance undertaking by the constructor guaranteeing that
the project facility will perform in accordance with certain technical
specifications;
i
Warranties for design, materials and equipment for a period of
approximately one or two years after project completion;
Li
Insurance provisions requiring the constructor to contract a
comprehensive insurance package covering all insurable risks
relating to the construction phase of the project prior to its
completion;
L Force majeure provisions to excuse construction delays or cost
over-runs caused by events beyond the control of the constructor;
u
Dispute resolution mechanisms.
4.2.3 Supply Agreements
The project company usually enters with one or more suppliers into longterm supply agreements for the purposes of the provision of the supplies
necessary for the start-up and operation of the project. The supplies provided
may include raw materials, gas, coal, fuel and other energetic resources.
Consequently, supply agreements are designed to give some certainty in respect
of the availability and the price of the necessary inputs to produce and deliver
78
project outputs. Supply agreements must be consistent with the terms of the offtake agreement.
Supply agreements usually include the following provisions:
L The commitment of the supplier to deliver sufficient quantities of
specific supplies in order to enable the project company to meet its
obligations under the off-take agreement;
u
The obligation of the supplier to ensure a quality of supplies that
meets the specifications under which the project facility was
designed;
u
Pricing provisions providing predictability of price over the life of the
project;
Li
Transportation provisions allowing the project company to receive
delivered supplies on the project site;
Li
Provisions requiring the supplier to pay liquidated damages in the
event that it does not comply with its delivery obligations;
Li
Dispute resolution mechanisms.
The term of the supply agreement typically has a length at least equal to
the term of debt financing. This helps to ensure that input costs are sufficiently
predictable for the project debt financing.
79
4.2.4 Off-take Agreement
In general, the project company enters with a governmental agency or a
private-sector company into a long-term purchase contract in respect with the
project outputs. Under the terms of an off-take agreement, the off-taker agrees
to buy a certain quantity of project output from the project company for a certain
period of time at a certain predetermined price. Such arrangement provides
certainty that the project after its completion will generate sufficient cash flow to
cover its operating expenses and service its debt. Therefore, an off-take
agreement provides project lenders with security and protects them from the risk
of not being paid.
An off-take agreement generally includes the following provisions:
u
Quantity and quality of the project output to be delivered, purchase
price and delivery schedule;
u
Incentive payments and low performance penalties in order to
encourage a project company to operate efficiently;
Li
A definition of force majeure consistent with the provisions under
the concession contract, the construction contract, the supply
agreements and the operating and maintenance agreement;
L Credit enhancement provisions relating to the off-taker payment
obligations;
u
Liquidated damages provisions;
u
Dispute resolution mechanisms.
80
The term of the off-take agreement typically has a length at least equal to
the term of debt financing. This helps to ensure that the generated cash flows
are sufficiently predictable for the project debt financing.
Undertaking an off-take agreement is not always possible. Certain
infrastructure projects, such as toll roads, toll bridges or telecommunication
networks generally are undertaken without any off-take agreement. In the case
of most infrastructure projects, there is no certainty of the project cash flow since
the utilization of such a particular infrastructure facility by the public is highly
unpredictable. For example, in the case of toll road projects, governmental
agencies that award a concession to a project company generally cannot
guarantee a certain number of users of the roads.
In the case of projects for which project output is a commodity, such as oil,
gold or copper, the project company may decide to undertake the project without
an off-take agreement. However, when project revenues are exclusively depend
on the market prices, the project company must hedge against the risk of
commodity price fluctuations. Hedging against such risk enables the project
company to give some certainty to the cash flow generated by the project and
support its debt financing.
4.2.5 Operating and Maintenance Agreement
A project company has two options for project operation. It can either
operate the project by its own means, without contracting any operating and
81
maintenance agreement, or delegate the operation, maintenance and
management of the project facility to an operator. Under the terms of an
operating and maintenance agreement, the operator must ensure that the project
is operated, managed and maintained according to specific performance criteria
in order to meet the off-take agreement requirements. Similar to the
constructor's responsibility, an operator is responsible for all aspects of project
operation and maintenance. Nevertheless, the operating and maintenance
agreement is not as critical to the project as is the construction contract since the
operator can be replaced without major consequences.
An operating and maintenance agreement generally includes the following
provisions:
u
Description of the general services to be provided by the operator,
such as performing day-to-day operation, management and
maintenance activities; dealing with the various project contractors;
procuring the necessary equipment; selecting, training and
managing employees for operation;
Li
Preparation of an annual budget for the operation and maintenance
of the project;
L Administration of project contracts including the coordination of
supply deliveries under the supply agreements and output
deliveries under the off-take agreement;
Li
Insurance provisions requiring the operator to secure
comprehensive insurance package covering the operating phase;
82
i
Dispute resolution mechanisms.
When the operation and maintenance of a project facility are carried out
by the project company itself, it may eventually arrange for some technical
assistance under the terms of a technical assistance agreement.
4.2.6 Cash Contribution Agreement
Completion of the construction phase of a project is an important step to
ensure the overall success of the project. Therefore, project lenders, who need
assurances regarding the project completion, usually require that the project
sponsors enter into a cash contribution agreement with the project company.
Under the terms of a cash contribution agreement, the project sponsors agree to
provide the project company with additional funds during the construction phase
to support construction cost over-runs or cash shortfalls not foreseen in the
financial plan to enable the project to be completed. A cash contribution
agreement may ensure that in the event of default of project completion the
project sponsors must pay back the debt financing in full. In general, project
lenders want to have the right to enforce project sponsors to comply with the
terms of the cash contribution agreement. This protects lenders from project
completion risk.
83
4.3
Project Finance Contractual Arrangements Structure
Figure 4.1 summarizes a typical project finance contractual arrangements
structure with some of the major participants involved in a project finance
transaction.
Fig. 4.1: Project finance contractual arrangements structure. Adapted from Buljevich and Park.
84
5 Project Financing Structures
Chapter 4 has shown that the object of the contractual arrangements is to
provide all parties involved in the project with the incentives to act efficiently by
transferring the risks to those best able to manage them. For example,
construction risks are borne by the constructor and the risk of insufficient demand
of the project's output is borne by the purchaser.
Since there is a limit to how much can be written into a contract and how
efficiently that contract can be monitored, contractual arrangements need to be
complemented by financial arrangements. This set of financial arrangements
seeks to constrain the parties involved in the project to acting on the interest of
the project. In infrastructure projects, for example, the main constructor typically
is one of the investors in the project. This equity participation provides the
constructor with an incentive to be efficient in the construction of the project
facility since the project profits depend directly on how well the project facility is
built.
5.1
Types of Capital and Debt
Before analyzing the appropriate proportions of the different types of
capital to be used to finance a project, which is the object of the project capital
85
structure section, this section presents the three types of capital used in project
financing: equity, quasi-equity, and senior debt.
5.1.1
Equity
"The equity investment in a project represents the risk capital.19" It refers
to funds put into a project by either the project sponsors or passive investors who
are not directly involved in the project promotion. Equity capital is typically
provided in the form of common or preferred stocks. Lenders advancing more
senior forms of capital to the project look to these funds as a commitment by the
project sponsors to the project, and therefore as a safety margin. Project
financiers typically require equity investments, which are generally provided by
the owners of the project, because equity contributions mean a lower risk for
them.
Equity investors are the last in priority for repayment in case of default of
the project company. However, the expected rate of return on their investment
can be substantial. This expectation is the motivating factor for investors
providing equity capital to the project.
The appropriate proportions of debt and equity for a given project are a
matter for negotiation between the project sponsors and the project lenders since
19
Nevitt, Peter K., Project Financing: Fourth Edition, London: Euromoney Publications, 1983,
Chapter 4.
86
these two types of project participants do not necessarily have the same target
capital structure.
5.1.2 Quasi-equity
Quasi-equity consists of subordinated loans or advances to a project,
which is senior to equity capital but junior to senior debt. Subordinated loans can
sometimes be used for advances required by project investors to cover
construction cost over-runs or other payments necessary to maintain debt-toequity ratios in order to avoid increasing interest rates.
Quasi-equity has numerous advantages over capital contributions.
According to Nevitt (1983), quasi-equity typically provides the following
advantages:
Li
Subordinated debt has a specific schedule for interest payments
and repayment of principal, whereas dividends on stock are
optional;
u
Interest paid on debt is deductible for income tax purposes;
Li
Governmental agencies that cannot take an equity position in a
project for policy reasons may be able to provide subordinated debt
in order to attract senior debt to the project.
87
5.1.3 Senior Debt
Most borrowings from commercial banks for project financing are done in
the form of senior debt. Senior debt is debt that is not subordinated to any other
liability. Thus, senior debt holders are the first in priority for repayment in the
event the project encounters difficulties in servicing its debt. Such lenders
receive payments according to a specific schedule and a predetermined interest
rate.
Senior debt could fall into two categories 20 : unsecured and secured loans.
Such a distinction is important since secured senior debt holders have an
advantage over unsecured senior debt holders. Secured loans are loans for
which the project's assets are given as collateral. Such assets must be
marketable, and therefore could be converted to cash to pay back the lenders.
For example, in a fully secured loan, the value of the assets securing the debt
equals or exceeds the amount borrowed. Lenders generally rely on the value of
the collateral for repayment. However, the standing of the project sponsors and
the probable success of the project also enter into the lending decision.
On the other hand, unsecured loans are only backed by the general credit
of the borrower and not secured by any type of asset. Since projects tend to be
new ventures with no operating histories, unsecured loans are generally
20
Nevitt, Peter K., Project Financing: Fourth Edition, London: Euromoney Publications, 1983,
Chapter 4.
88
available to projects whose project sponsors have good reputations and sufficient
capital or subordinated loans to meet the capital needs of the project.
5.2
5.2.1
Project Capital Structure
Project Financial Leverage
Project companies are generally highly leveraged. Project financial
leverage, also called debt ratio, is defined as the ratio of debt to total capital. The
average debt ratio for project financing is approximately 60% - 70%, but in some
projects it could be higher. In fact, the level of debt a project can achieve
depends on numerous factors, such as (1) the expected project's profitability, (2)
the nature and the magnitude of the risks associated with the project, (3) the
strength of the contractual arrangements among the project participants, and (4)
the creditworthiness of the parties that provide credit support through contractual
arrangements.
The project leverage does not remain constant. Its value changes over
time. For a typical project, the debt ratio starts at 0%, rises to somewhere in the
neighborhood of 60% - 80%, and then decreases to 0% in later years. This
evolution of the project leverage during the project's life impacts on the financial
valuation of the project. Indeed, the cost of equity, which is used to discount the
free cash flows generated by the project, changes with the leverage. Therefore,
89
the use of a single discount rate for all years based on the project's target capital
structure can lead to serious valuation errors. Esty (1999) showed how to
address this problem using multiple discount rates rather than a single discount
rate. Under this method, each discount rate for every year is based on the
corresponding leverage. Damodaran (1994) and Grinblatt and Titman (1998)
also recommend this approach. Nevertheless, this approach is not unanimously
recommended and most valuation books, such as Ehrhardt (1994) and Finnerty
(1996), recommend using the project's target capital structure to calculate the
appropriate discount rate. So, the project leverage can significantly influence the
project's valuation and its determination is an important step to assess the
profitability of a proposed project.
5.2.2 Reasons of High Project Financial Leverage
In general, project companies are highly leveraged. Such leverage occurs
despite the fact that it is difficult to attract potential lenders and that the
arrangement of such a capital structure is costly. Moreover, lenders generally
lend directly to the project company with only a limited recourse to the sponsors
in case of default of the project company. This observation precludes the idea
that the debt is a "cheap" source of finance and rises the question of why loans
are not directly made to the sponsors.
There are plenty of explanations on the high concentration of debt in the
project company but none of which appears to resolve completely this question.
90
In their article "Using Project Finance to Fund Infrastructure Investments, "
Brealey, Cooper, and Habib advance some of the more common reasons of such
a high concentration of debt in the project company.
Bankruptcy Costs:
Typically the projects undertaken by project companies have low
bankruptcy costs than those undertaken by the project sponsor. This is because
the project's assets are essentially tangible and the efficiency with which the
project facility is operated is not really affected by a change in ownership.
Consequently, if the bankruptcy costs of the sponsor are higher than those of the
project company, it could be more efficient to isolate the debt in the project
company to ensure that a potential bankruptcy of the project does not affect the
sponsor's business. The low cost of bankruptcy for project companies may
therefore explain why project companies use such a high debt level.
Taxes:
When a project is located in a high-tax country and the project sponsor in
a lower-tax country, it may be beneficial for the project sponsor to locate the debt
in the high-tax country to maximize its interest tax shields. Nevertheless, the
difference in tax rates does not explain (1) why lenders have limited recourse to
the project sponsor and (2) why the project company is so leveraged when both
21
Chew, Donald H., Stern, Joel M., The Revolution in Corporate Finance: Third Edition, Danvers,
Massachusetts: Blackwell Publishers, 1997, pp. 223-236.
91
the sponsor and the project company are submitted to the same tax
considerations.
Political Risk:
The difficulty of writing a comprehensive concession agreement with a
host government provides the need for financing arrangements that prevent the
government from taking actions that may render the project unprofitable. One
such arrangement is for the host government to take equity in the project
company. Another is an extensive reliance on limited recourse financing. By
concentrating debt in the project company, the sponsors ensure that the cost of
adverse government action falls directly on lending banks and agencies.
Lenders generally consist of a syndicate of major banks from a wide range of
countries, national and multinational agencies such as the World Bank, the
International Finance Corporation, and the Asian Development Bank. All have
considerable political influence, and can prevent the host government from acting
against the interest of the project. Moreover, the national and the multinational
agencies, which generally hold subordinated debt, are further exposed to the
consequences of adverse government actions. In contrast, the commercial
banks tend to hold senior debt in the project.
In addition, the national and the multinational agencies also provide loan
guarantees, which are generally intended to protect lenders against political risk.
For example, the World Bank may assist the project company in raising debt by
92
offering a partial risk guarantee that covers the host government's contractual
obligations and political force majeure risks.
Protection against political risk may explain the debt structure of project
companies in developing countries but does not explain why the same debt
structure is also used in politically stable countries.
Consequently, the need of protection against political risk for projects undertaken
in developing countries, where political decisions can be made against the
prosper development of the project, can explain that the project sponsors choose
to incorporate these projects in a separate company using a large amount of
debt. This choice is mainly motivated by the guarantees that multinational
agencies can bring into the project. From the equity investors' point of view, this
debt structure can be considered as a method to mitigate political risks and
ensure them a higher rate of return.
Information Costs:
Generally, when lenders award a loan, they need to evaluate the
creditworthiness of the borrower and monitor the use of the assets financed by
the loan. A possible benefit of the project finance, and of the associated lack of
recourse, is that lenders have to focus on evaluating and monitoring the project
only. This consequence of the limited-recourse structure can be seen as an
advantage for the lenders since they reduce their costs in evaluating and
monitoring the project.
93
Free Cash Flow:
According to Michael Jensen (1986), companies with a surplus of cash
and lack of worthwhile projects have tendency to invest this cash in negative netpresent-value projects rather than return it to shareholders. Consequently,
leverage ensures that cash is used to service debt. Nevertheless, this argument
does not explain why the debt is located in the project company rather than in the
parent companies. There are two possible reasons to explain the location of the
debt in the project company. One is that the sponsors may find it difficult and
costly to monitor the use of free cash flow within the project company, and
therefore cannot prevent the risk of reinvesting it unproductively. The other is
that, when there is more than one parent company, the owners may have
different views about how to use cash. By ensuring that cash flows are used to
service debt, such disagreements are avoided.
Another reason that can explain that the project company is characterized
by a high debt-to-total capitalization ratio is that the project sponsors seek to
preserve their debt capacity. By concentrating debt in the project company,
sponsors do not change their debt-to-equity ratio, and consequently conserve
their capacity of borrowing. Therefore, since the cost of debt increases with the
leverage, the sponsors seek to avoid increasing their debt level when
undertaking new projects. Consequently, the sponsors can undertake profitable
projects, which provide an acceptable rate of return to their equity investors,
without changing their debt standing and increasing their cost of debt.
94
5.3
2
Construction Financing
The development of a project finance transaction requires the project
sponsors to arrange both construction financing and permanent financing.
Construction financing ensures the availability of sufficient financial resources to
complete the construction phase of a project. Construction financing typically is
arranged through bank loans provided by commercial banks or direct loans from
the project sponsors.
5.3.1
Bank Loan Facility
One alternative for construction financing is to have the project company
or a special-purpose financing entity borrow short-term funds for construction
directly from commercial banks. If a special-purpose financing vehicle is used,
the project company would borrow the money raised by this entity under terms
identical to those under which this entity borrowed the money. Under this
alternative for construction financing, lenders secure their loans on the same
contractual arrangements that those used by long-term lenders in connection
with the permanent financing. Figure 5.1 shows the two possible ways for project
sponsors to raise funds to finance the construction phase of a project.
2
This section is based on Finnerty, John D., Project Financing: Asset-Based Financial
Engineering, New York: John Wiley & Sons, Inc., 1996.
95
_Cornmercial
Banks
Commercial
Banks
Special-purpose
Vehicle
Fianin
Debt
Service
Short-term
Debt Financing
Project
Company
Project
Company
Fig. 5.1: Ways of financing the construction phase of a project.
Construction loans usually are disbursed in multiple drawdowns based
upon a construction loan disbursement schedule and subject to the occurrence of
certain major events for engineering, procurement, construction, testing, and
start-up of the project facility.
5.3.2 Direct Loan by the Sponsors to the Project Company
A second alternative for construction financing is to have each of the
project sponsors borrow its share of the required construction financing directly
from commercial banks, and then lend such funds to the project company.
Following project completion, the project company arranges long-term debt
financing for the operation of the project facility. The project company then
96
repays its debt to the project sponsors using the proceeds of the long-term debt
financing. Figure 5.2 shows this second alternative in which the project sponsor
is directly involved.
Comrnercial
Banks
Project Sponsors
Project
Company
Fig. 5.2: Way of financing the construction phase of a project in which the project sponsor is
involved.
This alternative has a structure similar to that using a special-purpose
financing entity. In both cases, the project company does not have any direct
relationship with the project lenders. Nevertheless, there is an important
difference that must be considered between these two alternatives. Indeed, the
alternative involving the project sponsors makes the project sponsors directly
responsible for all the completion risk. In this particular situation, the project
sponsors bear the construction risk and have to pay back the project's debt even
though the construction of the project facility is delayed or not completed.
Therefore, to eliminate this liability, the project sponsors should transfer the
97
construction risk to the construction company. This could be done by arranging
turnkey construction contracts with the firms in charge of the construction.
The alternative in which either the project company or a special-purpose
financing entity arranges the debt financing with the project lenders is quite
advantageous for the project sponsors. Indeed, in this case, the project
sponsors limit the lender's recourse to their assets and reduce their exposition to
the completion risk. On the other hand, the high concentration of debt within the
project company associated with a high cost of debt reduces the expected
project sponsors' rate of return. Nevertheless, the project sponsors have a
greater interest in using the alternative in which they play only a role of credit
support for the debt financing. Being not directly involved in the financing of the
construction phase of the project, they limit their liability.
5.4
Long-term Financing
Investors are generally reluctant to advance funds for more than two years
without receiving any interest payments. Thus, there will be some uncertainty as
to whether permanent financing can be arranged before construction
commences for projects with lengthy construction periods. Moreover, investors
often require assurances that all the needed funds for the project development
have been secured. Consequently, commitments covering all the funds required
for the project from its development phase to its operation phase must be
arranged at the same time. The long-term financing is generally provided by
98
either mezzanine financing, which consists of different types of debt, or capital
market instruments.
5.4.1
Mezzanine Financing
The long-term financing usually consists of pure senior debt or a
combination of senior debt and subordinated debt or preferred stock. This
arrangement of different types of debt is sometimes called "mezzanine
financing." Senior debt typically is provided by commercial banks, export credit
agencies, multilateral and bilateral agencies.
The long-term loans are typically disbursed upon the occurrence of project
completion and are applied to take out the construction loan, which is specifically
used for the financing of all the construction and start-up project costs, and
provide sufficient cash to operate the project facility. Securing such financing
commitments generally requires that the project sponsors enter into a completion
agreement with the project company. Such commitments are designed to
provide project lenders with a strong guarantee that the project facility will be
completed (1) in due time, (2) at the price agreed by the parties to the
construction contract, and (3) according to the technical specifications.
A project company may arrange mezzanine financing when project
economics are strong enough to easily cover the payment of debt service and all
operating and maintenance costs. Such a financing structure offers investors an
intermediate return on investment between senior lending and common equity
99
investment and carries a corresponding intermediate risk. Mezzanine financing
may be useful to complement the traditional 2/3 capital structure for project
financing adding a 1/3 of capital between senior debt and common equity. Thus,
it can be used to reduce the exposure of senior lenders, equity investors or both
to a project. However, mezzanine financing may raise certain complex issues
between senior lenders and mezzanine investors as to, for example, uses of
revenues of a project or sharing of payments.
5.4.2 Capital Market Financing
The long-term debt financing can also be provided by a myriad of capital
market instruments, such as project bonds, floating-rate notes, and commercial
papers. Although the use of capital markets for purposes of financing a project
through a public offering or a private placement of debt securities, called "project
bonds", has increased dramatically over the last few years, such a financing
alternative still raises issues not present in the more traditional commercial bank
lending. Buljevich and Park (1999) advanced the following issues:
i
The use of capital markets is not in most cases an option for
financing project construction because investors generally are
reluctant to bear construction risk. On the contrary, once the
project has been completed and has successfully operated for a
reasonable period, capital market investors may be prepared to
100
purchase project bonds for the refinancing of the construction loans
at a lower cost.
L Proceeds from the sale of debt securities are typically received in a
single disbursement. However, projects usually require the
flexibility of multiple disbursements consistent with the project
schedule and budget. Consequently, this lack of flexibility usually
prevents project companies from using a capital market financing.
Li
Traditional lenders, such as commercial banks, export credit or
multilateral agencies, offer greater flexibility to a project company
than a capital market facility does. The ability of a project to quickly
react to any changing circumstances is a key element of a
successful project financing. Banks, export credit or multilateral
agencies are relatively easy to mobilize rapidly if an unforeseen
event occurs. This is not the case of capital market investors and
calling a meeting of bondholders is time consuming, costly, and
does not insure a satisfactory result.
L As opposed to traditional forms of lending, project bonds require an
appropriate rating by one of recognized rating agencies in order to
tap either the public or institutional investor markets. Without a
grade rating, issuing project bonds usually is a risky business and
is not considered as the best alternative to raise funds for a project.
Li
Capital market facilities are not easy to integrate as part of a
financial plan that consists of several other types of lenders.
101
Actually the negotiation between traditional lenders on the one side
and bondholders in the other side is a hard and time-consuming
process.
L Capital market issues require the disclosure of sensitive information
to prospective investors. Generally project sponsors are reluctant
to disclose such information to the public and prefer to keep this
information within a limited number of interlocutors.
Nevertheless, capital market funding may be a viable alternative for
project financing as it can provide a fixed-rate financing at a cheaper cost and for
a term usually longer than traditional lenders offer.
5.5
Project Financing Structures over Project Phases
The cash flow requirements of a project vary depending on the stage of
the project. A typical project can be divided into three major phases:
development, construction, and operation. To meet the financial requirements of
each phase the project company has to find an appropriate financing structure.
102
5.5.1
Project Development Phase
During the development phase of a project, which can be lasted several
years depending on the size and the complexity of the project, the project
requires funds to support its development. Such funds are used to perform
extensive engineering feasibility studies. These studies must be as detailed as
possible since construction and operating costs are directly dependent on the
effectiveness of the original design specifications. Project developers generally
retain outside engineering consultants to assist with design work and assess the
project's technological feasibility. On the other hand, long-term lenders often
require independent expert opinions, which are designed to provide them with
guarantees that the project facility can be constructed within the time schedule
and construction cost estimated and operated according to proposed
specifications. During this phase, the project requires funds to be developed but
does not produce any revenues. Moreover, at that time, the project has little or
none tangible assets. Thus, the only way to finance the project during its
development phase is through equity investments. Figure 5.3 shows the
financing structure used to finance the development phase.
103
LENDERS
*Commercial Banks
-Export Credit Agencies
'pMultilateral Agencies
LENDERS
-Commercial Banks
*Export
Credit Agencies
-Multilateral Agencies
PROJECT
COMPANY
Equity in the form of
Common Stock and Cash Contributions
MEZZANINE
INVESTORS
Fig. 5.3: Financing Structure during the Development Phase.
5.5.2 Project Construction and Start-up Phase
The detailed engineering and design studies made during the
development phase provide the basis for estimating the construction costs.
Construction cost estimates should include the cost of the project facilities and all
the necessary additional infrastructure costs, which have in general to be borne
by the project sponsors, to support project construction. In addition to these
costs, these estimates should also include a contingency factor to cover possible
design errors or unforeseen costs. The size of this factor depends on
uncertainties that may affect construction, but a 10% is generally viewed as
sufficient in most projects if the design has been finalized. Construction cost
estimates have also to take into account the project's working capital
requirements as well as the interest payments due during the construction phase.
104
Generally, the construction phase is not considered as completed before the
project facility has been operated for a successful test period, which can last
several years depending on the complexity and technological innovation of the
project facility.
During the construction phase, the requirements of funds increase considerably
and project sponsors often are not the ability to support all the construction costs.
Thus, equity investments must be completed by other sources of funds. During
this period, financing comes mainly from debt financing. Figure 5.4 shows the
financing structure used during the construction phase before project completion.
LENDERS
LENDERS
-Commercial Banks
Export Credit Agencies
Multilateral Agencies
-Commercial Banks
*Export Credit Agencies
Multilateral Agencies
Short-term Debt Financing
(Construction Financing)
PROJECT
COMPANY
Equity in the form of
Common Stock and Cash Contributions
NvZAIN
Fig. 5.4: Financing Structure during the Construction Phase before project completion.
In this period, debt increases as a result of the use of a credit line, typically
provided by commercial banks at high interest rates, and the addition of the
interest to the total debt. Therefore, the project leverage increases and becomes
very high. At that particular time, the project is highly exposed to the financial
105
risk. Figure 5.5 shows the financing structure at the time of project completion
where the construction debt is taken out with the permanent debt.
LENDERS
PER
*Commercial Banks
-Export Credit Agencies
*Multilateral Agencies
Interest and Principal Payments
of Short-term Debt Financing
(Construction Financing)
Long-term Debt Financing
(Senior Debt)
PROJECT:
COMPANY:
UROEC
Subordinated Debt
Preferred Stock
Cash Contributions
JVESTOS
Fig. 5.5: Financing Structure at the time of project completion.
5.5.3 Project Operation Phase
During the operation phase, the project commences to generate revenues,
which are used to pay back the project debt and eventually provide return to
equity holders on their investments. Over time, the project debt and financial risk
decline. During this phase, the project does not require any major funds and the
generated project cash flows are to be sufficient to cover debt service and
operating and maintenance expenses. Nevertheless, in the early stages of the
operation phase, additional working capital can be needed to operate
successfully the project facility, and it is generally provided by project sponsors.
106
Thereafter such additional working capital, if needed, is provided by project cash
flows. Figure 5.6 shows the financing structure used during the operation phase.
LENDERS
Banks
*Export Credit Agencies
eMultilateral Agencies
eCommercial
Interest and Principal Payments
of Long-term Debt Financing
(Permanent Fina ncing)
PROJECT:
COMPANY:
Interest and Principal Payments
Return on Investment
Return on Investment
PROJECT
V*
SPONSORS
Fig. 5.6: Financing Structure during the Operation Phase.
107
6 Examples of International Project Finance
Transactions
The previous chapters illustrated the framework of international project
finance transactions. The present chapter seeks to be more practical and,
through a series of projects financed on a project-financing basis, to show the
variety of applications. After a description of each project, the ownership and
financing structures are presented. Finally, presentation of each project is
completed by establishing the key elements that have made the project specific.
6.1
The Indiantown Cogeneration Project
The Indiantown Cogeneration Project 23 involves the construction and
operation of a coal-fired cogeneration facility having a net design electric
generating capacity of 330 megawatts, in Martin County, Florida.
A limited partnership was formed in October 1991 to develop, own,
construct, and operate the project facility. The partnership entered into a 30-year
power purchase agreement with Florida Power & Light Company.
23
This example is based on Finnerty, John D., Project Financing: Asset-Based Financial
Engineering, New York: John Wiley & Sons, Inc., 1996.
108
General partners are Toyan Enterprises, a wholly owned subsidiary of
Pacific Gas & Electric Enterprises, and Palm Power Corporation, a wholly owned
subsidiary of Bechtel Enterprises, Inc. The limited partner is TIFD lll-Y Inc., a
wholly owned subsidiary of General Electric Capital Corporation. The ownership
structure is illustrated in Figure 6.1.
Pacific Gas & Electric Enterprises I
Bechtel Enterprises, Inc.
100e Ownership
To.
General Electric Capital, Inc.
1007 Ownership
-Ense
--
e -orpora-ion
12 % Ownership
4 q Oncrship
100% Ownership
I
TF
I-0
,Ic
40 7 Ownership
1009 Ownership
0nintw Cogeneratio
Fig. 6.1: Simplified ownership structure for the Indiantown Cogeneration Project.
The initial construction financing for the project came from four sources:
Li Commercial bank loans, which reached $202 million as of June
1994;
Li A $113 million issue of tax-exempt bonds;
Li A $139 million loan from GE Capital;
o $100,000 of partners' capital.
109
Indiantown (the project company) and Bechtel Power Corporation entered
into a turnkey construction contract, which covered the design, engineering,
procurement of equipment and all materials, construction, start-up, and testing of
the cogeneration facility. The fixed price for the cogeneration facility under the
construction contract was $439 million. The construction began on October 1992
and Bechtel Power was obligated to achieve substantial completion by January
1996. Final completion had to occur no later than December 1996. Figure 6.2
shows the schedule for the project - from the formation of the limited partnership
responsible for the development of the project to its completion.
Oct. '91
Nov '94
Oct. '92
Jan. '96
Dec.
Fg
Cz.
E0)
a
U-
!E
U)
-z
E
0
0
-t0)
E)
Fig.
6.2:
The
Indiantown
W
c-a
C-
EJ
C
0
a)0
0
0_):3
0U
0
Cogeneration
Project
schedule.
110
On November 1994, the partnership refinanced the project with the
proceeds from the sale of:
* $505 million of first mortgage bonds issued by Indiantown;
*
$125 million of tax-exempt bonds issued by the Martin County
Industrial Development Authority and lent to Indiantown.
Figure 6.3 shows the project's capital structure reached just after the
refinancing of the project.
Amount
Percent
First Mortgage Bonds
$505
65.6%
1994 Tax-exempt Bonds
$ 125
16.2 %
$ 630
81.8 %
$140
18.2%
$ 770
100 %
Long-term Debt
Total Long-term Debt
Equity
Partners' Equity
Total Capitalization
Fig. 6.3: Capital structure upon project refinancing (Dollar Amounts in Millions).
The project financing arranged for the Indiantown Cogeneration Project
illustrates that the public debt market can be a potential funding source for
projects involving low technological risk. This example also shows that, under
certain conditions, the refinancing of a project may take place prior to its
completion. Nevertheless, such refinancing is rare in project financing since, in
general, the construction risk is borne by either the construction company or the
project sponsors. In this particular case, refinancing has been reached because
of (1) the high quality and reputation of the project's sponsors, (2) the strength of
the project's contractual arrangements (Power Purchase Agreement, Turnkey
111
Construction Contract, Coal Purchase Agreement, Coal Waste Transportation
Agreement...), (3) the implementation of a conventional proven technology, and
(4) the high probability of project completion on the due date, and within the
project budget.
6.2
The Melbourne City Link Project
The AUD$1.8 billion Melbourne City Link (MCL) Project 2 4 is Australia's
largest privately funded public infrastructure project. MCL is a BOOT toll road
project. It connects three of the city's major freeways and improves traffic
movement around and into the city center.
In 1995, the state government of Victoria granted Transurban, the project
company, a concession to design and construct City Link and to operate it and
levy tolls for a period of 34 years. The concession essentially provides
Transurban with the right to build, own, and operate the project facility before its
transfer back to the state.
The project's sponsors Transfield and Obayashi Corporation formed a joint
venture to develop, construct, and operate the City Link Project. Transfield is a
leading Australian infrastructure developer, which was successfully involved in
2
This example is based on Arndt, Raphael H., " Risk Allocation in the Melbourne City Link
Project, " The Journal of Project Finance, Fall 1998, and information from
http://www.transfield.com.au/ and http://www.mcla.vic.gov.au/.
112
the Sydney Harbour Tunnel Project opened in 1992. Obayashi Corporation is
one of the world's largest companies with extensive experience in road, bridge,
and tunnel construction.
The financial bottom line for this project was to construct and operate City
Link at minimal cost and at no risk to the Victorian taxpayers. It was funded by a
sophisticated financial package.
The project's sponsors raised AUD$510 million in equity. Of this,
AUD$455 million came from listed equity in Transurban, which was listed
successfully on the Australian Stock Exchange on March 1996, and AUD$55
million from deferred equity from the sponsors.
The total debt raised was AUD$1.365 billion giving the project a debt-toequity ratio of 1,365 / (1,365 + 510) = 73 %. Of this, AUD$865 million was
traditional syndicated senior debt. Transurban used a separate, subordinated
bank loan of AUD$150 million to purchase the electronic device motorists must
place in their vehicle to use the roads. Finally, AUD$350 million came from rated
bonds.
In order to better allocate and share project risks, the project participants
agreed to develop and use a new tool, known as the Material Adverse Effect
(MAE) Regime. This tool was designed to provide flexibility over the life of the
project and cope with unforeseen risk events. The goals of the process are to
resolve unforeseen events that can impact the project's profitability and to avoid
triggering traditional dispute resolution mechanism. This process is divided into
four stages:
113
i
The occurrence of an event that can cause a risk for the project;
u
The event is material, meaning that it has an effect on the ability of
a project sponsor to repay the project debt in accordance with the
amortization schedule or the level of disbursement, and the
expected project equity return to Transurban's investors;
Li
The opening up of negotiation between the parties to resolve the
issue and to determine the likely consequences of the event
occurring;
Li
Assuming that consensus is reached, the form and nature of
redress are determined from the following range of options:
.
Amending the toll calculation schedule;
" Varying the concession period;
" Altering the risk allocation;
" Varying the rights of the state to receive payments;
"
Requesting lenders to restructure project financing
arrangements;
*
Asking the state to make a financial contribution to the
project.
Such variety of compensation methods allows greater flexibility in
determining what action to take to resolve any unforeseen event that can impact
the profitability of the project. This process is dynamic and flexible enough to
resolve large issues that a project can encounter during its lifetime.
114
Transaction and monitoring costs associated with this process, which may
be quite high, may preclude its utilization. Nevertheless, such costs are
expected to decrease with parties involved in its development gaining more
experience. Moreover, the apparent success of the MCL project proves that
complex issues can be efficiently resolved throughout the MAE process.
The project financing arranged for the Melbourne City Link Project, which
has been opened to the public since the beginning of year 2000, illustrates that
risk allocation and risk sharing are mechanisms that play a significant role for
ensuring the success of a project finance transaction.
6.3
The Tribasa Toll Road Project
Mexico has developed and realized an extensive system of toll roads in
the recent years2 5 . In general, these roads have been financed either with
public-sector funds or by public programs designed to stimulate private-sector
participation in infrastructure development. In the case of private-sector
participation, the concession holder, who is responsible for arranging project
financing, typically has the right to build or improve, operate, and maintain a
highway for a specified period of time before its transfer back to the government.
25
This example is based on Finnerty, John D., Project Financing: Asset-Based Financial
Engineering, New York: John Wiley & Sons, Inc., 1996.
115
According to the public program for infrastructure development, Grupo
Tribasa, throughout two wholly owned subsidiaries, obtained two toll road
concessions in Mexico. These concessions entitled Grupo Tribasa to construct,
operate, and maintain these two toll roads.
A combination of equity financing from the project's sponsor and other
local sources of financing funded the construction and initial operation of both toll
roads.
In 1993, the project was refinanced after Grupo Tribasa had successfully
operated the toll roads for a few years. The funds raised for the refinancing of
the project came from $110 million of 10.5 percent notes issued under the Rule
144A.
Rule 144A, adopted in April 1990 by the Securities and Exchange
Commission, is a rule that liberalized the restrictions that had existed on trading
unregistered debt and equity securities. Prior to the adoption of Rule 144A, the
U.S. securities laws imposed significant restrictions on the resale of unregistered
securities, which rendered such securities illiquid. Thus, private placement
buyers, interested in acquiring these securities, demanded a higher interest rate,
which penalized the resale of such securities. With the adoption of Rule 144A,
debt securities issued under Rule 144A are considered "quasi-public" securities.
Consequently, the issuer can sell its securities to investment banks that in turn
resell them to qualified institutional buyers. These institutional buyers of Rule
144A debt offerings generally are large life insurance companies. These
companies are receptive to such securities if they are rated investment-grade by
116
major rating agencies, which apply to these securities the same criteria that they
use to rate public debt securities. Consequently, only completed and
successfully operating projects may issue Rule 144A debt securities.
Although the Tribasa Toll Road Project met all of these requirements, the
profitability of the project, and therefore the creditworthiness of the notes are still
dependent on the volume of traffic using the roads. Grupo Tribasa
commissioned a detailed traffic report, prepared by independent experts, to
enable prospective purchasers of the notes to quantify the economic risks of the
toll roads, and therefore the credit risks of the notes. The traffic report provided a
detailed operating history of the toll roads and also analyzed the business and
financial prospects of the project.
The Tribasa Toll Road Project and its refinancing illustrates that the
project financing technique can also be used for refinancing existing successfully
operated projects. It demonstrates that capital can come from the international
financial market for infrastructure projects that are able to put in place strong
credit support arrangements.
117
6.4
The Sydney Harbour Tunnel Project
In 1987, the New South Wales State government decided to build a
tunnel, close to the Sydney Harbour Bridge, to provide a second harbour
crossing 26 . The Sydney Harbour Tunnel is a 4 lane, 2.3-kilometer road tunnel.
From December 1985 to March 1986, Transfield and Kumagai Gumi, in
joint venture, undertook a pre-feasibility study. They completed it by a detailed
feasibility study carried out between March and December 1986. This feasibility
study involved the detailed planning and design work for the development of a
complete BOOT proposal for the project.
Final agreement to undertake the project on a BOOT basis was reached in
June 1987 between the Sydney Harbour Tunnel Company (jointly owned by
Transfield and Kumagai and serving as project company) and the Roads and
Traffic Authority of NSW. Construction of the tunnel commenced on July 1987,
was completed on schedule, and opened to traffic on August 1992. The
concession agreement entitled the Sydney Harbour Tunnel Company to operate
the tunnel for 30 years.
The Sydney Harbour Tunnel agreement fixed the capital cost of the
project at AUD$554 million. In addition to the direct design and construction
26
Information in this section was provided by Project Financing, A Supplement To Euromoney,
August 1988.
118
cost, interest payments, government taxes, and other costs brought the total
project value to be financed at AUD$770 million.
Westpac Bank provided an innovative package to finance the project,
which it had worked for two years to put together. Funds for the project came
from three sources:
ci
Loans from the Sydney Harbour Tunnel Company partners of
AUD$40 million (AUD$20 million each);
u
A loan from the government raised from excess Sydney Harbour
Bridge toll revenue earned during construction of the tunnel,
totaling AUD$223 million and payable in 2022;
Li
AUD$506 million from 30-year bonds.
The Sydney Harbour Tunnel Project was the first BOOT project in New
South Wales. Its apparent success encouraged successive governments to
develop a number of other Australian urban roads using this innovative and cost
effective method of delivery. The Sydney Harbour Tunnel has transformed the
Sydney Harbour crossing with significant reduction in travel times and a marked
improvement in reliability for both public and private transport.
The tunnel is currently exceeding its revenue projections. Nevertheless,
the Sydney Harbour Tunnel agreement has been criticized as a public
underwriting of private-sector profits. The agreement was structured in such a
way that, while the private sponsors agreed to bear some development, design,
and construction risks, the majority of the financing, demand, and operational
119
risks were left with the government. Indeed, the state government not only
directly contributed to the costs of construction, but also underwrote the revenue
stream of the long term indexed bonds, which was the main financing instrument,
irrespective of the actual usage of the road.
120
Conclusion
Project financing is a well-known financing technique that has a long
history. Recently, infrastructure, oil and gas, telecommunication, and other types
of large capital-intensive projects have been successfully developed by private
entities that have relied on project financing as a financing technique.
Project financing is a financing technique by which project lenders agree
to look to the expected project cash flows as the basis of their credit analysis and
as the main source of repayment, independently of the credit standing of the
project developers. In other words, "project financing can be arranged when the
project is capable of standing alone as an independent economic unit."
This thesis has examined the ownership and financing structures that are
currently used to shape a project finance transaction. Throughout the description
of mechanisms used both to select the best form of business organization to
undertake a project and to structure the financial package supporting the
financing of a project, this thesis has proposed a basic framework for developing
a project finance transaction.
Selection of the ownership structure for a project is an important step in
project development. The determination of the best form of business
organization to undertake a project is dependent on a myriad of factors, such as
proportion of debt and equity investment, tax and accounting considerations, and
legal and regulatory issues. There are basically four ownership structures that
121
are currently used for developing a project on a project-financing basis: (1)
corporation, (2) general partnership, (3) limited partnership, and (4) joint venture.
Each of these basic forms of business organization has its advantages, which
can make it attractive, but also its disadvantages. For example, the corporate
form of organization, which is probably the most common ownership structure
selected for structuring a project finance transaction, offers the advantage of
limited liability and the benefits associated with the creation of a separate legal
entity. Nevertheless, the borrowing cost for the project sponsors could be higher
since the debt leverage of the project company may be greater than that of the
project sponsors. Another ownership structure frequently used is the general
partnership form of organization, typically selected when the project sponsor
does not have sufficient financial resources or expertise to pursue a project on its
own. So, the project sponsor, by forming a partnership, has the opportunity to
undertake a new profitable project. This advantage is, however, balanced by the
fact that the general partnership structure does not afford limited-recourse
liability. Therefore, the selection of the best form of business organization
remains a difficult process, which is highly dependent on the project itself.
The project company usually enters into project contracts with different
project contractors for the purposes of the development of the project. Some of
these project contracts, such as the off-take agreement, the supply agreement,
or the construction contract, are designed to give some certainty to the project.
For example, the off-take agreement provides certainty that the project, after its
final completion, will generate sufficient cash flow to cover its operating and
122
maintenance expenses and meet all its debt service obligations. Similarly, the
supply agreements give some certainty in respect to the availability and the price
of the inputs needed to produce the project's outputs.
The object of the contractual arrangements is also to provide all the
parties involved in a project with the incentives to act efficiently by transferring
the risks to those best able to manage them. For example, construction risks are
borne by the constructor and the risk of insufficient demand of the project's
outputs is borne by the output purchaser. These contractual arrangements are
complemented by financial arrangements that constrain the project participants
to act on the interest of the project.
The financial arrangements are designed to ensure that a project will have
sufficient financial resources to be completed and operated during its lifetime.
These financial arrangements provide the project developers with assurances
that all the needed funds for the development of the project are secured. They
also provide the project lenders with guarantees of the payment of debt service
by the project company. In project financing, the funds required for the
development of a project come from three types of capital: equity, quasi-equity,
and senior debt. Each type of capital reflects the level of exposure of the relative
investor, and its expected financial rate of return. For example, equity capital
refers to funds put into a project by the project sponsors or by passive investors,
in the form of common or preferred stock. So, the equity holders are the last in
priority for repayment in case of default of the project company. Consequently,
since they are highly exposed to project risk, they demand a substantial rate of
123
return to bear all this risk. This source of capital represents in general less than
1/3 of total capital. On the contrary, commercial banks advance funds for a
project in the form of senior debt, which is not subordinated to any other liability.
One feature common to any project company is its high concentration of
debt. Several reasons are generally given to explain this debt structure: the low
cost of bankruptcy for project companies, preferred tax and accounting
considerations, or protection against political risk.
The financing of a project is a dynamic process and requires different
forms of debt financing instruments. So, the development of a project requires
the project sponsors to arrange both construction financing and permanent
financing. Construction financing, provided in the form of short-term debt, is
needed to ensure the availability of sufficient financial resources to complete the
construction phase of a project. Permanent financing, provided in the form of
long-term debt, is applied to take out the construction loan and provide sufficient
cash to operate the project facility. Permanent financing usually consists of
senior debt or a combination of subordinated and senior debt. Sometimes, the
long-term debt financing for a project is also provided by capital market
instruments. These financial instruments are in general not an option for
financing the construction phase of a project. This is simply because capital
market investors are reluctant to bear construction risk. On the other hand, once
the project has been completed and operated for a reasonable period of time,
capital market investors may be prepared to purchase project bonds to refinance
124
the project. So, the development of sophisticated capital market products
provides the project sponsors with an increasing flexibility to finance a project.
The examples provided in Chapter 6 show that the project financing
technique is a powerful tool for developing and financing large capital-intensive
projects. These examples point out that project contracts are the foundation for
the success of a project finance transaction. To be efficient, these contracts
must be consistent and work together as a whole. These examples also illustrate
that most of the issues relating to the structuring of a project finance transaction
can be addressed by project contracts. For example, in the Indiantown
Cogeneration Project, the off-take agreement was critical for supporting the debt
financing by ensuring the project would generate sufficient cash flow. This
project shows also the important role of the project sponsors. Indeed, the
refinancing of the project, which has been reached before the end of the
construction phase, came essentially from the reputation of the project sponsors.
This example reveals that for projects involving low technological risk developed
by reputable project sponsors, the project financing technique has begun a
common financing tool. The Melbourne City Link Project indicates that a
concerted and dynamic risk allocation is crucial to resolve unforeseen events that
impact the project's profitability. The Tribasa Toll Road Project illustrates that the
project financing technique can be used for the refinancing of an existing
successfully operated infrastructure project. This example also shows that the
refinancing can be reached by tapping into the international financial markets.
125
Finally, to be successful, the project financing technique must carefully
address the risk allocation process, the determination of the form of business
organization, and the arrangement of a consistent set of contractual and financial
agreements. Resolution and integration of these three elements are the
challenge of any project finance transaction.
126
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